Quick Answer
Match product to profile using four factors (risk tolerance, time horizon, objectives, liquidity), and resolve conflicts toward the more conservative one. Diversification kills only unsystematic risk; beta measures systematic risk; alpha measures skill above the Capital Asset Pricing Model expected return. In rising prices, First-In, First-Out lifts earnings and taxes while Last-In, First-Out lowers both.
The whole unit on one sheet: the profile filter, the portfolio-theory statistics, the two accounting-policy choices, and the numbers the exam loves.
Core Concepts
- Four profile factors drive product selection: risk tolerance, investment time horizon, investment objectives, liquidity needs. Evaluate the profile as a whole; when factors conflict, the more conservative one wins.
- Diversification reduces unsystematic (diversifiable) risk only; it leaves systematic (market) risk untouched. Answer to "the market going down" is asset allocation, not more stocks.
- Concentration is the mirror image: an outsized position in one security, sector, issuer, or geography. The representative must flag it across the whole portfolio, even positions they did not recommend.
- Volatility is price fluctuation over time; pair it with time horizon first. Long horizons absorb volatility; short horizons and income-dependent investors cannot.
- Beta = systematic risk vs. the market (market beta = 1.0). Alpha = actual return minus Capital Asset Pricing Model (CAPM) expected return (manager skill).
- Fundamental analysis reads the three core statements for intrinsic value; footnotes carry the accounting methods and contingent liabilities.
The One-Liners That Win Points
- Beta over 1.0 = aggressive; under 1.0 = defensive; 1.0 = moves with the market; 0 = risk-free asset. Beta cuts both ways: a beta of 1.5 gives 50% more upside AND 50% more downside.
- Alpha is measured against CAPM expected return, not the raw market return. Compute CAPM first, alpha second.
- CAPM = risk-free rate plus beta times the market risk premium. The market risk premium is market return minus risk-free rate, never the market return alone.
- First-In, First-Out (FIFO) sends older costs to Cost of Goods Sold; Last-In, First-Out (LIFO) sends newer costs. In rising prices FIFO looks more profitable and LIFO pays less tax.
- Depreciation, depletion, amortization are not interchangeable: depreciate tangible assets, deplete natural resources, amortize intangibles. All three are non-cash expenses. Land is never depreciated.
- Diversified fund (Investment Company Act): the 75-5-10 rule.
- A sector fund is not diversified across sectors, even if it satisfies 75-5-10 within its industry.
Numbers to Lock In
| Item | Value / Relationship |
|---|---|
| Market beta | 1.0 by definition |
| CAPM | expected return = risk-free rate + beta x (market return − risk-free rate) |
| Market risk premium | market return − risk-free rate |
| Alpha | actual return − CAPM expected return |
| Diversified fund test | 75% of assets diversified, 5% max per issuer, 10% max of an issuer's voting stock (remaining 25% unconstrained) |
| Straight-line depreciation | (cost − salvage value) ÷ useful life |
| Rising prices, FIFO | higher earnings, higher taxes, higher inventory on the books |
| Rising prices, LIFO | lower earnings, lower taxes, lower inventory on the books |
| Variable annuity early withdrawal | 10% penalty before age 59½ (ordinary income, LIFO) |
Memory Aids (reuse verbatim)
- Alpha is what the manager adds beyond what beta already explains. Beta describes the ride; alpha describes the driver's skill.
- FIFO follows the older prices to COGS (first in, first out means the oldest units leave first).
- LIFO follows the newer prices to COGS (last in, first out means the newest units leave first).
- 75-5-10 = 75% of assets, 5% per issuer, 10% of issuer's voting stock. The remaining 25% is unconstrained.
Top Gotchas
- Never rank funds on raw return alone. A fund returning 18% with beta 2.0 can have negative alpha; a 12% fund with beta 1.0 can beat it on risk-adjusted terms. Compute CAPM first.
- High beta is not "bad," it is aggressive. Match beta to the profile, not to a good/bad label.
- CAPM starts at the risk-free rate, not zero, and assumes the investor is fully diversified (which is why only systematic risk appears). Beta is historical, so it is an estimate, not a promise.
- Reinvested mutual fund distributions are still taxable in the year received. Municipal bond interest inside an Individual Retirement Account (IRA) wastes the federal exemption.
- Tax treatment informs but never overrides suitability. A tax-advantaged product that fails the profile filter is still unsuitable; a suitable product with a tax drag stays suitable.
- Pair volatility with time horizon first. A self-described aggressive customer with a one-year horizon is still unsuitable for equity funds.
- The balance sheet is a snapshot; income and cash flow statements cover a period. Form 10-K is audited; Form 10-Q is not. Risk factors are ordered by importance.
- A single mutual fund can still be diversified in substance if it is a target-date or balanced fund; the question is whether the underlying holdings are spread.
One-Breath Recap
Run every recommendation through the four profile factors and let the more conservative one break ties. Diversification and beta both speak to market versus company risk, alpha measures skill above the CAPM expectation, and in rising prices First-In First-Out flatters earnings while Last-In First-Out saves taxes. Match volatility to time horizon, read the footnotes, and let tax treatment inform but never override suitability.
Need more than the recap? This is a condensed summary. If it is not enough, read the full Investment Strategies and Analysis unit for the complete lesson.