e.g. Guide to Financial Planning
Have you heard? All the children in Lake Woebegone are above average. And, everyone you know who returned from vacation in Las Vegas told you they ‘broke even’.
It's no different when it comes to investing. Everyone loves to talk about the stock they own that’s done well for them. It makes you wonder if people love to focus on their gains and conveniently ignore their losses... or costs.
It seems no one is ever below average; but somebody MUST be? Innumerable independent studies have consistently shown that individual investors seem to do far worse than the market averages – and it doesn’t seem to matter which average you use – many, if not the majority, still continue to invest like poor people instead of doing what the wealthy do. And, that may explain why so many are ill-prepared financially for the future they insist they seek.
One individual last week told me he wanted to retire in three years with a $600,000 nest-egg. Without telling him that $600,000 may not do the trick – that depends on his spending habits – I asked him how much he had right now. His answer: $60,000. And, he's sure he can do it, despite the fact he has only $60,000 after many years of working already.
If you’ve wondered how sophisticated you might be, I’ve devised a simple, short, and admittedly unscientific five-question quiz. If you get all five right, I think you might be fairly sophisticated. If you get four right, I’d say you’re possibly above average. If you get three right, you’re probably someone who is fairly aware but may want to get some help. Anything less: Turn off the tv and find a qualified professional.
So, just for the fun of it, here it is. If you have to cheat, the answers are at the end. No one will know except you.
1. Diversifying your investment portfolio helps you reduce which risk:
4. None of the above
2. The best measure by which to evaluate a company’s ability to satisfy debts with highly liquid assets is the:
1. Acid-test ratio
2. Current ratio
3. Relative strength ratio
4. Capitalization ratio
5. Profitability ratio
3. The best measure of a portfolio’s total risk is:
2. Standard deviation
3. The Capital Asset Pricing Model (CAPM)
4. Which method of return calculation is most appropriate for evaluating the rate of return for an individual investor?
1. Time-weighted return
2. Dollar-weighted return
3. The Sharp index
4. Monte Carlo analysis
5. Which of the following is NOT a probable effect of raising the reserve requirement of the Federal Reserve?
1. Tightening of the money supply
2. Lead to higher stock prices
3. Raise interest rates
4. Slow down the growth of GDP (gross domestic product)
You didn’t’ cheat, did you? Want to know how you did?
Here are the correct answers:
1. 2: Business risk. Each company has its own competitive risks. Diversification can reduce this risk. Market risk cannot be diversified away. In fact, if you bought all the stocks in the market, you would only replicate market risk, not reduce it. Economic risks affect the entire market.
2. 1: Acid-test ratio. Also called the ‘quick ratio’ is used because it eliminates the inventory factor from the calculation (it is included in the current ratio) and permits a better reading of the liquidity position of the business.
3. 2: Standard deviation. This is the measure of total risk in the portfolio because it measures its variability of returns, regardless of market factors. Beta measures a portfolio’s volatility, not variability, relative to some benchmark index.
4. 2: Dollar-weighted returns. Also called internal rate of return (IRR), this measures total return on a portfolio from inception and includes the effects of all cash inflows and outflows. Time-weighted returns measure portfolio performance without regard to cash flows either in or out and is therefore used for evaluating the performance of portfolio managers. Sharp is expressed as the ratio of excess return of the total portfolio to its standard deviation. Monte Carlo simulations are used to conduct probability analysis.
5. 2: Higher reserve requirements with the banks leads to reduced lending which impedes growth and expansion for companies and are likely to cause stock prices to decline.
Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™ and in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional. The Independent Financial Group does not sell financial products or securities and nothing contained herein is an offer or recommendation to purchase any security or the services of any person or organization. Twitter: @JimLorenzen. Visit the IFG Blog. Plan Sponsors: Retirement Plan Insights.