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Are You A Sophisticated Investor?

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

All the children in Lake Woebegone are above average.

Everyone who returns from vacation at Las Vegas tells you they ‘broke even’.

Everyone loves to talk about the stock they own that’s done well for them.

No one is ever below average, it seems; but how true is it?   Despite the fact that 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.   He’s sure he can do it.  

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.  Anything less:  I hope you’re getting help.

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:
    1. Market
    2. Business
    3. Economic
    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:
    1. Beta
    2. Standard deviation
    3. The Capital Asset Pricing Model (CAPM)
    4. Alpha
  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?   The answers are below:

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.

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The Independent Financial Group is a fee-only registered investment advisor and does not sell products earn commissions, or accept any third-party compensation or incentives of any description.  IFG also does not provide tax or legal advice.  The reader should seek competent counsel to address those issues.  Nothing in this post should be accepted as investment advice which is provided only to IFG clients.  Opinions expressed in this piece are those of the author.  You can reach Jim at 805.265.5416 or through his website.