CFP Module 4 flashcards

32 cards. Read the term and the definition here. The deck at the top of this page is optional.

Net worth formula

Total assets minus total liabilities measured at a point in time. It excludes future income and is the starting benchmark for measuring progress toward financial goals.

Emergency fund target

Liquid reserves covering three to six months of essential expenses, extended to six to twelve months when income is variable, commission-based, or the household has a single earner.

Future value formula

FV equals PV multiplied by (1 + r) raised to the n periods. It assumes a constant rate and compounding, and is the basis for projecting lump-sum goal funding.

Real return

Nominal return adjusted for inflation, approximated as nominal minus inflation or exactly as (1 + nominal) divided by (1 + inflation) minus one. Use it to fund goals stated in today's dollars.

Human capital

The present value of a person's expected future earnings. It is the largest asset for many young clients and is protected through life and disability insurance.

Inflation-adjusted goal cost

Today's cost multiplied by (1 + inflation) raised to the number of years. This converts a stated goal into the future dollar amount that must actually be funded.

529 plan treatment

A tax-advantaged education account: contributions grow tax-deferred, qualified withdrawals are free of federal income tax, and the account owner keeps control of the assets.

Housing cost ratio

A common underwriting guideline limiting housing expense to roughly 28 to 36 percent of gross monthly income, with total debt service capped near 36 to 43 percent.

Portfolio expected return

The weighted average of each holding's expected return, where weights equal each asset's market value divided by total portfolio value.

CAPM formula

Expected return equals the risk-free rate plus beta multiplied by the market risk premium. Beta measures sensitivity to market movements, and the market itself has a beta of 1.0.

Sharpe ratio

Excess return above the risk-free rate divided by standard deviation. It measures reward per unit of total risk and allows comparison of portfolios with different volatility.

Systematic versus unsystematic risk

Unsystematic risk is company- or industry-specific and can be diversified away. Systematic risk is market-wide, cannot be eliminated, and is the risk that earns a premium.

Bond duration

The approximate percentage price change for a one percent change in yield. Higher duration means greater interest rate sensitivity, typical of longer maturities and lower coupons.

Two-asset portfolio variance

Variance equals w1 squared times sigma1 squared plus w2 squared times sigma2 squared plus twice the product of weights, volatilities, and correlation.

Asset location

Placing tax-inefficient holdings such as taxable bonds and REITs in tax-deferred accounts while keeping tax-efficient equities in taxable accounts to improve after-tax returns.

Rebalancing discipline

Returning holdings to target weights after market moves, using calendar or threshold triggers. It systematically trims winners and adds to laggards.

Realized compound yield

The actual return earned when coupon payments are reinvested at rates different from the yield to maturity. It equals YTM only if reinvestment occurs at that same rate.

Beta interpretation

A measure of a security's sensitivity to market movements. A beta above one amplifies market swings, below one dampens them, and exactly one matches the market.

Replacement ratio

The percentage of pre-retirement gross income needed in retirement, commonly 70 to 85 percent, adjusted downward for work expenses and upward for health care costs.

Sequence-of-returns risk

The danger that poor investment returns early in retirement, combined with withdrawals, permanently reduce portfolio longevity even if average returns are adequate.

Longevity risk

The risk that a retiree outlives available assets. It is managed through delayed Social Security claiming, annuities, and conservative withdrawal rates.

Safe withdrawal rate

The initial inflation-adjusted percentage of a portfolio that can be withdrawn annually with low historical failure probability over a stated horizon, often near four percent.

Delayed retirement credits

Benefit increases for claiming Social Security after full retirement age, roughly eight percent per year, stopping at age seventy. Claiming earlier permanently reduces the benefit.

Required minimum distributions

Mandatory annual withdrawals from tax-deferred retirement accounts beginning at the IRS-specified age. The amount equals the prior year-end balance divided by a table factor.

Defined benefit formula

A pension benefit typically calculated as years of service multiplied by a benefit factor multiplied by final average pay, often with survivor and cost-of-living options.

Rule of 72

Dividing 72 by a growth or inflation rate approximates the number of years required for a value to double. At three percent inflation, costs double in about 24 years.

Risk handling techniques

Four responses to pure risk: avoidance, loss reduction, retention through self-insurance, and transfer through insurance. Selection depends on loss frequency and severity.

Insurable risk requirements

Insurers need many independent exposure units, accidental and determinable losses, measurable loss amounts, and no catastrophic concentration that threatens solvency.

DIME needs method

A life insurance needs approach summing debt, income replacement, mortgage payoff, and education costs, then subtracting existing coverage and available assets.

Coinsurance clause

A property policy provision requiring coverage of a stated percentage of replacement cost. If underinsured, the claim is reduced proportionally to the shortfall.

Revocable living trust

A trust the grantor can amend or revoke, holding assets during life and passing them outside probate at death. It provides no estate tax reduction.

Marital deduction and portability

The unlimited marital deduction defers estate tax on transfers to a spouse. Portability lets a surviving spouse use the deceased spouse's unused exclusion amount.