Domain 4 - Investments
Domain 4 - Investments
This domain tests risk measurement, portfolio construction, security mechanics and the return calculations that let you compare alternatives on a consistent after-tax, risk-adjusted basis.
Risk and return
- Total risk is measured by standard deviation; systematic (market) risk by beta. Diversification removes unsystematic risk only; correlation below 1.0 produces the benefit.
- CAPM: expected return = risk-free + beta × (market return − risk-free).
- Sharpe ratio = (return − risk-free) ÷ standard deviation; Treynor uses beta. Higher is better.
- Time-weighted return measures the manager; dollar-weighted (IRR) measures the investor's actual experience.
Fixed income
Bond prices move inversely to yields. Modified duration approximates the percentage price change for a 1% yield change; convexity refines it for large moves. Compare municipal and taxable bonds with the tax-equivalent yield: municipal yield ÷ (1 − marginal rate).
Vehicles
- Mutual fund share classes: A (front-end load), B (contingent deferred sales charge), C (level 12b-1 load). ETFs trade intraday and are generally more tax-efficient.
- Annuities defer tax but convert gain to ordinary income and impose a 10% penalty before 59½.
- Options: a covered call caps upside and generates premium; a protective put sets a floor and costs premium.
- Asset location: put tax-inefficient holdings (REITs, high-turnover funds, taxable bonds) in tax-deferred accounts.
Behavioral finance
Overconfidence, anchoring, recency, loss aversion, mental accounting and herd behavior explain client deviations from the investment policy statement.
Worked example. A client in the 32% bracket can buy a 3.2% municipal bond or a 4.8% taxable corporate bond of similar quality and duration. Tax-equivalent yield = 3.2% ÷ (1 − 0.32) = 4.71%, which is below 4.8%, so the taxable bond wins. Now add duration: an 8-year modified duration bond portfolio loses roughly 8 × 0.75% = 6% of price if yields rise 75 basis points - a reason to match duration to the spending horizon.
Traps. Comparing raw yields without the tax-equivalent adjustment; treating beta as a measure of total risk; extrapolating recent returns; ignoring expense ratios compounded over decades; using arithmetic averages for multi-year projections; forgetting that fund loads and 12b-1 fees reduce net return.