Investment Foundations common mistakes
Investment Foundations · Understand the traps and how to avoid them.
Treating 'buy side' and 'sell side' as synonyms for 'investor' and 'broker', then mislabelling a firm such as an asset manager that also distributes its own funds, or a broker-dealer that trades for its own book.
Candidates memorise a one-line definition and never test it against hybrid firms. The exam deliberately uses firms that sit across the boundary, and the labels are about function in a transaction (providing capital versus providing execution/intermediation), not about the firm's legal name.
What to do instead
For every firm in a question, ask two questions separately: does it commit its own capital to take risk, and does it intermediate or execute for others? Classify by the role in the described activity, not by the company's headline business. Practise with a list of 10 firms and write both roles next to each.
Confusing the roles of the primary market, the secondary market, and a trading venue, e.g. saying an IPO raises money for the exchange, or that a secondary trade funds the issuer.
The words 'market' and 'exchange' get used loosely in study material. Candidates learn the definitions in isolation and then answer a scenario question by pattern-matching the word 'IPO' to 'primary market' without checking who receives the cash.
What to do instead
Draw the cash-flow arrow for every scenario: in a primary issuance cash goes from investor to issuer (net of fees to underwriters); in a secondary trade cash goes from buyer to seller, and the issuer receives nothing. Then ask where the venue sits. Do this for IPO, follow-on offering, block trade and ordinary screen trade.
Assuming a quoted price is a price at which a trade can be done, ignoring bid-ask spread, order size and depth, so a candidate picks the last traded price as the execution price or treats an indicative quote as firm.
Retail experience teaches that the screen price is the price. Candidates do not distinguish firm quotes from indicative quotes, or top-of-book from full depth, and so underestimate transaction costs and slippage in scenario questions.
What to do instead
For any pricing question, identify three things before answering: is the quote firm or indicative, what size is being traded, and is there depth at that level? Compute the all-in cost as half-spread plus commission plus expected market impact. Learn to explain why a large order fills worse than the screen price.
Mixing up money-market instruments with short-duration bonds, e.g. classifying a 2-year note or a floating-rate note as a money-market instrument, or treating commercial paper as long-term debt.
The boundary is a maturity convention (typically one year or less at issuance) rather than an economic property, and candidates rely on a vague sense of 'short term' instead of the convention. Floating-rate notes feel short-term because the coupon resets, which reinforces the error.
What to do instead
Anchor on original maturity at issuance: one year or less is money market (T-bills, commercial paper, certificates of deposit, repurchase agreements); beyond that it is a capital-market instrument, even if the coupon resets or the holder intends to sell soon. Build a two-column table and sort 15 instruments into it from memory.
Describing a bond's price-yield relationship only qualitatively ('prices fall when yields rise') and then failing numerical questions on duration, convexity or the effect of a coupon change.
Candidates learn the direction of the relationship but not its magnitude, so they cannot handle questions that ask which of two bonds falls more for a given yield change. They also forget that duration is a first-order approximation and that convexity makes the estimate asymmetric.
What to do instead
Learn the mechanics: modified duration times yield change times price gives the approximate percentage price change, and convexity adds a positive correction in both directions. Practise ranking bonds by duration given coupon, maturity and yield, and check each estimate against the intuition that lower coupon and longer maturity mean higher duration.
Treating a fund's past return, or a manager's star rating, as the expected future return when answering client-suitability or performance questions, and ignoring fees, benchmark and survivorship when comparing funds.
Performance tables are the most visible data in the industry, and candidates default to the number on the screen. They also compare funds on gross rather than net returns, or against different benchmarks, which makes the comparison meaningless.
What to do instead
Always ask three questions before using a track record: net or gross of fees, against which benchmark and over what period, and does the universe include funds that closed? For expected return, use the building-block approach (risk-free rate plus risk premia) rather than extrapolating history. State explicitly that past performance is not predictive.
Confusing arithmetic and geometric (time-weighted) mean returns, or compounding an annual return by simple multiplication, when answering multi-period return questions.
Candidates learn the formulas separately and then pick whichever appears in the question stem. They also forget that volatility drag makes the geometric mean lower than the arithmetic mean, so they overstate long-run wealth.
What to do instead
Decide first whether the question asks about a single period's expected return (arithmetic) or about realised wealth over many periods (geometric). Convert between them using the approximation that geometric mean is roughly arithmetic mean minus half the variance. Check every multi-year answer by compounding year by year rather than multiplying.
Answering a client-needs question with the technically best-performing product instead of the one that fits the client's objective, time horizon, liquidity needs and risk tolerance, and skipping the suitability step.
The exam rewards product knowledge, so candidates lead with the product they know best. They also treat risk tolerance as a single number rather than a combination of willingness and ability to bear risk, which can conflict.
What to do instead
Use a fixed sequence for every client scenario: objective, time horizon, liquidity requirement, ability to bear loss, willingness to bear loss, then constraints. Only after that do you select an instrument. Where willingness and ability conflict, the more conservative constraint governs and the conflict is documented.
Failing to separate the adviser's duty of loyalty from suitability, e.g. saying a disclosed conflict of interest removes the conflict, or recommending a higher-commission product because it was disclosed.
Candidates conflate disclosure with permission. Disclosure is a transparency obligation; it does not by itself make an unsuitable or conflicted recommendation acceptable. Study material often lists 'disclose conflicts' as a control, which invites the shortcut.
What to do instead
For each recommendation, ask whether it is in the client's best interest independent of the adviser's compensation, then ask whether the conflict was disclosed and managed. Treat disclosure as necessary but not sufficient. Practise writing one sentence that states the conflict, one that states how it was managed, and one that states why the recommendation still fits.
Mis-stating what a benchmark or index measures, e.g. treating a price-return index as total return, or comparing a portfolio to an index with a different universe or weighting, and then drawing a performance conclusion.
Index names are familiar and candidates assume they know the methodology. Differences between price, net and gross total return, and between cap-weighted and equal-weighted versions, are invisible unless the methodology is checked.
What to do instead
Before using any index, name its universe, weighting scheme and return type. When comparing a portfolio, restate both on the same basis (same currency, same return type, same period). Learn to explain in one sentence why a cap-weighted and an equal-weighted version of the same market give different returns.