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Introduction
1. Common stock
2. Preferred stock
3. Debt securities
4. Corporate debt
5. Municipal debt
6. US government debt
7. Investment companies
8. Insurance products
9. The primary market
10. The secondary market
11. Brokerage accounts
12. Retirement & education plans
13. Rules & ethics
14. Suitability
14.1 Product summaries
14.2 Investment objectives
14.3 FINRA suitability standards
14.4 Investor profiles
14.5 Best practices
14.6 Portfolio analysis
14.7 Economic analysis
14.8 Test taking skills
Wrapping up
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14.6 Portfolio analysis
Achievable Series 6
14. Suitability

Portfolio analysis

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Investors can use many tools and resources to analyze their portfolios and the economy. The topics below are closely related:

  • Total return
  • After-tax return
  • Benchmark comparisons
  • Capital asset pricing model (CAPM)
  • Modern portfolio theory
  • Economic analysis

Total return

Total return measures an investment’s overall gain or loss as a percentage of its original cost. In other words, it’s the investment’s overall rate of return.

A security can generate a return (or a loss) in three main ways:

  • Dividends
  • Interest
  • Capital gains and/or losses

Preferred stocks and some common stocks pay cash dividends as income. Debt securities pay interest as income.

Any security can also have a capital gain or loss:

  • A capital gain occurs when the market value rises above the cost.
    • Realized gains occur when you sell and “lock in” the gain.
    • Unrealized gains occur when you haven’t sold yet.
  • A capital loss occurs when the market value falls below the cost.
    • Like gains, losses can be realized (sold) or unrealized (not sold).

Total return includes all of these gains and losses and compares them to the original cost. Here’s the formula:

Total return=Original costAll gains and/or losses​

Although calculations are generally few and far between on the Series 6, total return is a common test topic. The following video shows how to approach a total return question:

Now, try one on your own:

An investor purchases 100 shares of stock at $50 per share. The investor receives two quarterly dividends of $1 per share after holding the security for six months, then sells the security for $55 per share. What is the total return?

Can you figure it out?

(spoiler)

Answer = 14%

Start with the total return formula:

Total return=Original costAll gains and/or losses​

You can calculate using total dollars or on a per-share basis. Either approach works. We’ll use a per-share approach to keep the numbers simple.

  • Dividends received: $1 per share per quarter × 2 quarters = $2 per share
  • Capital gain: $55 sale price − $50 purchase price = $5 per share
  • Total gain: $2 + $5 = $7 per share

Now plug into the formula:

Total return=$50 original cost$2 dividend + $ 5 capital gain​

Total return=$50 original cost$7 overall return​

Total return=14%

After-tax return

After-tax return is total return after accounting for taxes.

This can get tricky because different types of returns may be taxed at different rates. As covered in the tax considerations chapter, dividends and capital gains don’t always receive the same tax treatment.

Let’s work through an example:

An investor in the 24% tax bracket purchases 100 shares of ABC Equity Fund at $80 per share. Over the course of a year, they receive $2 quarterly dividends (per share). The investor redeems the fund at $90 per share exactly one year after purchase. What is the after-tax return?

First, identify the two sources of return:

  • Cash dividends
  • A realized short-term capital gain (a holding period of one year or less is a short-term capital gain)

For this investor:

  • Qualified* cash dividends are taxable at 15% (only the two highest tax brackets - 35% and 37% - use the 20% dividend tax rate).
  • Short-term capital gains are taxable at the investor’s tax bracket (24%).

*You can assume all dividend income paid from equity securities and funds is considered qualified and subject to 15% or 20% taxation, unless otherwise specified. If a test question identifies a dividend as non-qualified, it is taxable at the investor’s marginal income tax bracket (up to 37%).

Even though the investor purchased 100 shares, we can calculate on a per-share basis:

  • Dividends: $2 quarterly dividend × 4 payments = $8 per share
  • Capital gain: $90 − $80 = $10 per share

Applicable tax rates:

  • $8 in dividends, taxed at 15%
  • $10 in capital gains, taxed at 24%

To convert each return to an after-tax amount, multiply by (100% − tax rate):

  • Dividends: $8 × 85% = $6.80 after-tax
  • Capital gain: $10 × 76% = $7.60 after-tax

Now calculate after-tax return using the same structure as total return:

After-tax return=Original costAfter-tax returns​

After-tax return=$80.00 original cost$6.80 dividends + $7.60 capital gain​

After-tax return=$80.00 original cost$14.40 overal after-tax return​

After-tax return=18%

Here’s a video that breaks down after-tax return in more detail:

Benchmark comparisons

After you calculate the return on a portfolio or security, you’ll often compare it to a relevant benchmark index.

For example, large-company stocks are commonly compared to the S&P 500 index. If a stock is up 15% for the year while the S&P 500 is up 10%, the stock is outperforming the benchmark by 5%.

An index tracks the market prices of a pre-determined group of investments. For example, the S&P 500 tracks the stock prices of 500 of the largest US-based publicly traded companies, including Apple, JP Morgan Chase, and Amazon.

In general, an index reflects the average change in market prices of a basket of securities. Many indexes also apply weights, meaning some securities have a larger impact on the index than others. For example, changes in Amazon’s market price affect the S&P 500 more than changes in Alaska Airlines stock, because Amazon’s market capitalization is roughly 200 times larger. The larger the company, the more influence it typically has in a cap-weighted index.

Indexes typically use one of two weighting methods:

  • Price-weighted indexes give more weight to higher-priced stocks.
  • Cap-weighted indexes give more weight to stocks with higher market capitalizations.

These are the relevant indexes to know for the exam:

  • S&P 500
    • Tracks 500 large-cap stocks
    • Cap-weighted index
  • S&P 100
    • Tracks 100 large-cap stocks (a subset of the S&P 500)
    • Cap-weighted index
  • S&P 400
    • Tracks 400 mid-cap stocks
    • Cap-weighted index
  • Dow Jones Composite
    • Tracks 65 prominent stocks
    • Composite of DJIA, DJTA, and DJUA (see below)
    • Price-weighted index
  • Dow Jones Industrial Average (DJIA)
    • Tracks 30 prominent stocks (various industries)
    • Price-weighted index
  • Dow Jones Transportation Average (DJTA)
    • Tracks 20 prominent transportation stocks
    • Price-weighted index
  • Dow Jones Utilities Average (DJUA)
    • Tracks 15 prominent utilities stocks
    • Price-weighted index
  • Russell 2000
    • Tracks 2,000 small-cap stocks
    • Cap-weighted index
  • NASDAQ Composite
    • Tracks all stocks on NASDAQ exchange
    • Cap-weighted index
  • NASDAQ 100
    • Tracks 100 largest stocks on the NASDAQ exchange
    • Cap-weighted index
  • Wilshire 5000
    • Tracks all actively traded stocks in the US
    • Considered the broadest domestic index
    • Cap-weighted index
  • EAFE index
    • Tracks stocks in Europe, Australasia and Far East
    • Cap-weighted index

Capital asset pricing model (CAPM)

The capital asset pricing model (CAPM) estimates a security’s expected return using only factors related to systematic risk. CAPM uses this formula:

ER=RF + (Beta x (MR - RF))

Where:ERRFMR​=expected return=risk-free return=market return​

Each input ties back to market-related (systematic) risk:

  • The risk-free rate of return is the return on the 3-month (or 91 day) Treasury bill. Treasury bills aren’t literally risk-free, but they’re generally treated as the lowest-risk securities in the market.
  • Beta measures how volatile a security or portfolio has been relative to the overall market.
  • The market return represents the market’s expected return.

Example:

An investor is analyzing a large cap stock fund prior to making a potential purchase. The expected return of the S&P 500 is 12%, while the security reflects a beta of 1.5 and a standard deviation of 22. Additionally, the 3-month T-bill rate is 2%. Assuming the investor is utilizing the capital asset pricing model, what is the expected return of the large cap stock fund?

Can you figure it out?

(spoiler)

Answer = 17%

Identify the inputs:

  • Risk free rate = 2%
  • Beta = 1.5
  • Market return = 12%

Now plug them into the formula:

ER=RF + (Beta x (MR - RF))

ER=2% + (1.5 x (12% - 2%))

ER=2% + (1.5 x 10%)

ER=2% + 15%

ER=17% 

The standard deviation is not necessary to perform this calculation.

Notice what CAPM does not include: Non-systematic risks such as business risk, financial risk, and liquidity risk. The model is designed to estimate expected return based on market dynamics and systematic risk only.

If this formula looks familiar, it’s because it uses the same components as the alpha calculation. The difference is the goal:

  • CAPM calculates the expected return.
  • Alpha compares actual return to expected return to show overperformance or underperformance.

Modern portfolio theory (MPT)

In 1952, economist Harry Markowitz published an essay on investing often viewed as the foundation of modern portfolio theory (MPT). The essay, titled Portfolio Selection, laid out principles for building an efficient portfolio - one that targets the highest expected return for a given level of risk (or the lowest risk for a given expected return).

To develop these ideas, Markowitz made several assumptions about investors, including:

  • Investors share the same assumptions
  • Investors can borrow at the risk-free rate
  • Investors seek the highest return, but are also risk averse

These assumptions highlight a basic tradeoff: investors want higher returns, but higher returns generally require taking more risk. MPT’s key tool for managing this tradeoff is diversification.

A single security can be volatile (risky), but combining multiple securities can improve the portfolio’s overall risk/return profile. For example, losses in luxury cruise line stock during an economic downturn might be offset by gains in a defensive investment like pharmaceutical company stock.

With proper diversification, the risk/return profile of any one security becomes less important than the risk/return profile of the portfolio as a whole. That’s why a conservative, risk-averse investor might still allocate a small portion of assets to a higher-risk security and remain within a suitable overall portfolio.

To evaluate diversification benefits, investors often look at the correlation coefficient, which describes how two securities or portfolios have historically moved relative to each other. Correlation ranges from -1 to +1:

  • A correlation of +1 means the two move together in the same direction at the same rate.
    • Example: the S&P 500 index and an S&P index fund should maintain a correlation of 1.
  • A correlation of -1 means the two move in opposite directions at the same rate.
    • Example: the S&P 500 index should maintain a -1 correlation with an inverse S&P 500 exchange-traded fund (ETF). If the S&P 500 is up 10% in a day, the inverse ETF should be down about 10% that day. Over longer periods, this relationship can weaken because inverse funds reset their exposure daily.
  • A correlation of 0 means there’s no relationship.
  • A correlation of 0.5 suggests they move similarly about half the time.
  • A correlation of -0.5 suggests they move oppositely about half the time.

A key test point connects correlation to diversification: to diversify further, investors generally look for securities with negative correlation to the existing portfolio. Adding negatively correlated holdings can help reduce overall losses when the rest of the portfolio declines.

Diversification across securities is only part of the picture. Proper asset allocation also matters. Strategic asset allocation builds on MPT by emphasizing a suitable long-term allocation, avoiding market timing, and periodically rebalancing. Used correctly, it helps keep the portfolio’s risk/return profile aligned with the investor’s objectives.

Key points

Total return

  • Measures overall rate of return on a security or portfolio

Total return formula

  • Total return=Original costAll gains and/or losses​

After-tax return

  • Total return with taxes factored out

S&P 500 index

  • Tracks 500 large-cap stocks
  • Cap-weighted index

S&P 100

  • Tracks 100 large-cap stocks (a subset of the S&P 500)
  • Cap-weighted index

S&P 400

  • Tracks 400 mid-cap stocks
  • Cap-weighted index

Dow Jones Composite

  • Tracks 65 prominent stocks
  • Composite of DJIA, DJTA, and DJUA (see below)
  • Price-weighted index

Dow Jones Industrial Average (DJIA)

  • Tracks 30 prominent stocks (various industries)
  • Price-weighted index

Dow Jones Transportation Average (DJTA)

  • Tracks 20 prominent transportation stocks
  • Price-weighted index

Dow Jones Utilities Average (DJUA)

  • Tracks 15 prominent utilities stocks
  • Price-weighted index

Russell 2000

  • Tracks 2,000 small-cap stocks
  • Cap-weighted index

NASDAQ Composite

  • Tracks all stocks on the NASDAQ exchange
  • Cap-weighted index

NASDAQ 100

  • Tracks 100 largest stocks on the NASDAQ exchange
  • Cap-weighted index

Wilshire 5000

  • Tracks all actively traded stocks in the US
  • Considered the broadest index
  • Cap-weighted index

EAFE index

  • Tracks stocks in Europe, Australasia and Far East
  • Cap-weighted index

Capital asset pricing model (CAPM)

  • Financial model for determining the expected return
  • Only considers systematic risk

Expected return calculation

  • ER=RF + (Beta x (MR - RF))

Modern portfolio theory

  • Modern protocols and best practices related to investing
  • Goal: to attain the highest return potential with the smallest risk exposure
  • Overall risk/return profile of portfolio most important
  • Risk/return profile of individual securities not significant
  • Diversification necessary to reduce risk
  • Add negatively correlated securities to the portfolio to diversify

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