Formula Investing and Investment Strategies

Question 1

Dollar Cost Averaging

Answer 1

Dollar cost averaging is the practice of purchasing a fixed dollar amount of stock or stock funds at specified intervals. The logic behind dollar cost averaging is that by investing the same dollar amount each period instead of buying in one lump sum, you’ll be averaging out price fluctuations by buying more shares of common stock when the price is lower, and fewer shares when the price is higher.

Question 2

Dividend Reinvestment Plan (DRIP)

Answer 2

Under a dividend reinvestment plan (DRIP), you are allowed to reinvest the dividend in the company’s stock automatically without paying any brokerage fees. Most large companies offer such plans, and many stockholders take advantage of them.

Question 3

Bond Ladders

Answer 3

A ladder structure is a portfolio of bonds that mature at regular intervals throughout the various maturities of the yield curve. To perpetuate a ladder structure, as each bond matures, the proceeds are used to purchase a bond that will mature at the next interval after the one with the longest maturity in the portfolio. Ladders are most effective when the yield is normal or sloping upward and interest rates are fairly stable. Ladders are typically constructed using U.S. Treasuries or even CDs at a local bank.

Question 4

Barbell Strategy

Answer 4

A barbell is a strategy of holding more bonds at the short and long end of the yield curve with intermediate bonds being underweighted. This allows a portfolio’s price to match the volatility of an intermediate-term liability. When there is a likelihood that the Federal Reserve will loosen monetary policy in the near term, a barbelled portfolio may increase a bond portfolio’s return.

Question 5

Bullet Strategy

Answer 5

A bullet-structured portfolio benefits when the yield curve is expected to steepen. A bullet structure usually weighs heavier around intermediate term assets. A bulleted maturity tends to outperform a barbell structure when the yield curve steepens because in a rising rate environment, intermediate-term securities usually hold up better than long-term securities. Also, in a declining interest-rate environment, intermediate securities produce significantly greater price appreciation than do short-term securities.

Question 6

. Consider the following case: You invest $250 in stock every month over a period of a year. Which investment strategy are you applying?

A. Buy and Hold

B. Dollar Cost Averaging

C. Dividend Reinvestment Plan

D. All of the above

Answer 6

Correct Answer: B. Dollar Cost Averaging

Explanation: Dollar cost averaging is the practice of purchasing a fixed dollar amount of stock at specified intervals. The logic behind dollar cost averaging is that by investing the same dollar amount each period instead of buying in one lump sum, you’ll be averaging out price fluctuations by buying more shares of common stock when the price is lowest, and fewer shares when the price is highest.

Question 7

Your client owns a stock fund in a joint account with his wife. He elected to have the distributed dividends and capital gains reinvested back into the fund. Which of the following statements are true?

A. The reinvestments will have a dollar cost average effect on the account.

B. Since he did not take the dividends and distributed capital gains as cash, he will not need to pay taxes on them.

C. The reinvested amounts will not affect the cost basis of the account.

D. The reinvested amounts will purchase additional shares.

Answer 7

Correct Answers: A. and D.

Explanation: Reinvestment of dividends and distributed capital gains is a method to purchase additional shares rather than taking the amounts as cash. Since it is a purchase on a regular basis, it is gives the effect of dollar cost averaging. The cost basis of the account will change because the additional shares will be purchased at different share prices. Although the client does not take the money out of the account, the dividends and distributed gains are still taxable.

Question 8

Which of the following statements is true about a normal yield curve?

A. Short-term yield is lower than long-term yield.

B. A portfolio with a bullet strategy is best suited to this environment.

C. A portfolio with a ladder strategy is best suited to this environment.

D. A portfolio with a barbell strategy is best suited to this environment.

Answer 8

Correct Answers: A. and C.

Explanation: A ladder structure will be the most beneficial in a normal upward sloping yield curve indicating higher yield at longer maturities, with a stable interest rate environment. Barbells work better in a flat yield curve while bullet works better for a steep yield curve.

Question 9

Dollar cost averaging is a risk reduction method that would lower risk and likely increase return. Which of the following market conditions would be the LEAST favorable for dollar cost averaging?

A. Stock price is on the rise

B. Stock price is dropping

C. Stock price is level

D. Stock price is fluctuating

Answer 9

Correct Answer: A. Stock price is on the rise

Explanation: Dollar cost averaging can help investors lower their overall average cost per share in most market conditions except for when the stock price is continuously increasing. In that case, the investor would have been better off investing everything at the lower price in the beginning.

Question 10

Passive Managers

Answer 10

Passive managers generally act as if the security markets are relatively efficient. Put somewhat differently, their decisions are consistent with the acceptance of consensus estimates of risk and return. The portfolios they hold may be surrogates for the market portfolio, known as index funds, or they may be portfolios that are tailored to suit clients with preferences and circumstances that differ from those of the average investor. In either case, passive portfolio managers do not try to outperform their designated benchmarks.

Question 11

Active Managers

Answer 11

Active managers believe that from time to time there are mispriced securities or groups of securities. They do not act as if they believe that security markets are efficient. Put somewhat differently, they use deviant predictions; that is, their forecasts of risks and expected returns differ from consensus opinions.

Question 12

Technical Analysts Methodologies

Answer 12

Charting Strategies

Sentiment Indicators

Flow of Funds Indicators

Market Structure Indicators

Question 13

Charting Strategies

Answer 13

Charting Strategies involve the examination of historical price patterns, moving average and trading breakout techniques.

Question 14

Sentiment Indicators

Answer 14

Sentiment Indicators include contrarian statistics and one of the most accurate of all technical indicators, the Barron’s Confidence Index.

Question 15

Flow of Funds Indicators

Answer 15

Flow of Funds Indicators examine the amount of funds that are available to invest.

Question 16

Market Structure Indicators

Answer 16

Market Structure Indicators involve looking at the desirability of the overall market and opportunistic entry points.

Question 17

Contrarian Indicators

Answer 17

Odd Lot Activity

Short Sale Interest

Bullish/Bearish Index:

Question 18

Odd Lot Activity

Answer 18

An odd lot is a trade that takes place for an amount of shares that is less than 100. When the net activity of odd lot orders is for purchases, this will be a sell signal for a technician. When the net odd lot activity is for sale orders, this will be viewed as a buy signal. For the most part, small, non-institutional investors initiate these odd lots. The view on Wall Street is that the large institutional investors represent the so-called smart money, and that the small independent individual investor will always time the general market direction incorrectly.

Question 19

Short Sale Interest

Answer 19

Every month, the financial newspapers publish the amount of open interest of stocks that have been sold short. When short selling reaches record levels (or even high levels) that will be viewed as an extremely bullish signal. You may be tempted to think that many investors have short stock positions, so therefore stock prices must be headed lower. Actually, since short selling represents a contractual obligation to buy back the underlying securities, this represents a certain demand for those securities. Therefore a technician would view record levels of short selling as a very bullish signal.

Question 20

Investment Advisors Bullish/Bearish Index:

Answer 20

Periodically, professional investment advisors are polled in order to obtain their opinions as to where the major market indices will be in a year. If more than 50% of the advisors polled are bullish, that will be a sell signal for a technician. If more than 50% of the advisors polled are bearish, that will be a buy signal. The irony is that professional investment advisors do not seem to know any more than small, independent investors!