COMPREHENSIVE REVIEW for the CFP CERTIFICATION EXAMINATION Volume I Topics 1 41 Revised February 2016 For the July 2016 Exam Published by: KEIR EDUCATIONAL RESOURCES 4785 Emerald Way Middletown, OH 45044 1-800-795-5347 1-800-859-5347 FAX E-mail customerservice@keirsuccess.com www.keirsuccess.com 2016 Keir Educational Resources 1.1 800-795-5347
TABLE OF CONTENTS Title Page Keir Study Tips Tip 1: The THINK LIKE A PLANNER SM Method of Study Study Tips-1 Tip 2: How to study the comprehensive review package Study Tips-3 Tip 3: Instructor support for your questions Study Tips-7 Tip 4: Tips for answering multiple choice questions Study Tips-8 Tip 5: Keir s ten test-taking tips Study Tips-14 Tip 6: Projected allocation of CFP Certification Examination questions Study Tips-15 Tip 7: Allocation of the required 200 to 300 study hours to adequately prepare for the exam Study Tips-15 Tip 8: Full virtual review classes for the CFP Certification Examination Study Tips-16 Tip 9: Live review classes for the CFP Certification Examination Study Tips-17 Tip 10: Preliminary Assessment of Certification Examination Readiness (PACER Examination) Study Tips-19 Tip 11: Keir s After-Study Assessment Exam Study Tips-20 Tip 12: 12-Week Self-Study Plan Study Tips-21 Tip 13: Accelerated 8-Week Self-Study Plan Study Tips-36 Tip 14: Selected facts and figures for the CFP Certification Examination Study Tips-46 Tip 15: CFP Certification Exam Kick-off Call Study Tips-59 Tip 16: Keir guarantee Study Tips-60 Tip 17: What Keir students are saying about our Review Program for the CFP Certification Examination Study Tips-61 Job Task Domains Professional Conduct and Regulation (Topics 1-7) Topic 1: CFP Board s Code of Ethics and Professional Responsibility and Rules of Conduct 1.1 1.29 Topic 2: CFP Board s Financial Planning Practice Standards 2.1 2.14 Topic 3: CFP Board s Disciplinary Rules and Procedures 3.1 3.28 Topic 4: Function, Purpose, and Regulation of Financial Institutions 4.1 4.9 Topic 5: Financial Services Regulations and Requirements 5.1 5.27 Topic 6: Consumer Protection Laws 6.1 6.12 Topic 7: Fiduciary 7.1 7.7 2016 Keir Educational Resources 1.2 800-795-5347
TABLE OF CONTENTS (Continued) Title Page General Financial Planning Principles (Topics 8-16) Topic 8: Financial Planning Process 8.1 8.34 Topic 9: Financial Statements 9.1 9.11 Topic 10: Cash Flow Management 10.1 10.14 Topic 11: Financing Strategies 11.1 11.10 Topic 12: Economic Concepts 12.1 12.21 Topic 13: Time Value of Money Concepts and Calculations 13.1 13.20 Topic 14: Client and Planner Attitudes, Values, Biases, and Behavioral Finance 14.1 14.16 Topic 15: Principles of Communication and Counseling 15.1 15.14 Topic 16: Debt Management 16.1 16.15 Education Planning (Topics 17-21) Topic 17: Education Needs Analysis 17.1 17.7 Topic 18: Education Savings Vehicles 18.1 18.15 Topic 19: Financial Aid 19.1 19.11 Topic 20: Gift/Income Tax Strategies 20.1 20.7 Topic 21: Education Financing 21.1 21.18 Risk Management and Insurance Planning (Topics 22-32) Topic 22: Principles of Risk and Insurance 22.1 22.17 Topic 23: Analysis and Evaluation of Risk Exposures 23.1 23.8 Topic 24: Health Insurance and Health Care Cost Management (Individual) 24.1 24.26 Topic 25: Disability Income Insurance (Individual) 25.1 25.17 Topic 26: Long-Term Care Insurance (Individual) 26.1 26.11 Topic 27: Annuities 27.1 27.19 Topic 28: Life Insurance (Individual) 28.1 28.50 Topic 29: Business Uses of Insurance 29.1 29.36 Topic 30: Insurance Needs Analysis 30.1 30.9 Topic 31: Insurance Policy and Company Selection 31.1 31.12 Topic 32: Property and Casualty Insurance 32.1 32.45 Investment Planning (Topics 33-41) Topic 33: Characteristics, Uses, and Taxation of Investment Vehicles 33.1 33.40 Topic 34: Types of Investment Risk 34.1 34.10 Topic 35: Quantitative Investment Concepts 35.1 35.33 Topic 36: Measures of Investment Returns 36.1 36.33 Topic 37: Asset Allocation and Portfolio Diversification 37.1 37.17 Topic 38: Bond and Stock Valuation Concepts 38.1 38.33 Topic 39: Portfolio Development and Analysis 39.1 39.12 Topic 40: Investment Strategies 40.1 40.28 Topic 41: Alternative Investments 41.1 41.29 Formulas Formulas 1 Tables Tables 1 Index Index 1 2016 Keir Educational Resources 1.3 800-795-5347
To show a representative sample of our materials, we are showing selections from Topic 12. Economic Concepts (Topic 12) Learning Objectives (a) Apply the following economic concepts and measures in making financial planning recommendations 1) Supply and demand 2) National Income Accounts (including GDP) 3) Business cycles (unemployment, recession, fiscal and monetary policy) 4) Interest rates (including its term structure and the yield curve) and inflation 5) Exchange rates Economic Concepts A. Opportunity Cost B. Supply and demand C. Fiscal policy D. Monetary policy E. Economic indicators F. Business cycles G. Inflation, deflation, and stagflation H. Yield curve I. Exchange rates Opportunity Cost The concept of opportunity cost is that the choice to pursue an action means foregoing an alternative. When making a choice between two options, a planner must always consider the opportunity cost of what has been given up. Opportunity cost exists with all decisions. For example, choosing to go to the movies incurs an opportunity cost of not being available to exercise at the gym instead. When a financial planner makes a recommendation or a client chooses a particular action, the opportunity cost is calculated based on the next best alternative. In economics, a business will determine the best allocation of its resources according to its opportunity cost. The opportunity cost of producing one product is equal to giving up production of the next most attractive product. When the government makes spending decisions, it must factor in opportunity cost. For example, if a certain amount of dollars is spent on defense, those dollars are not available to pay for other government services such as health care. Opportunity cost will vary for each individual, each company, and each nation when decisions are made regarding 2016 Keir Educational Resources 1.4 800-795-5347
allocating resources. Supply and Demand Demand is the amount of a good or service that buyers are willing to purchase. Normally, the lower the price of the item, the greater will be the quantity demanded. This general law of demand is reflected in a demand curve that, as shown below, slopes downward from left to right. Supply is the amount of a good or service that producers are willing to sell. Normally, the higher the price of the item, the greater will be the quantity supplied. This general law of supply is reflected in a supply curve that, as shown on the next page, slopes upward from left to right. In a market economy, prices are determined by the interaction of supply and demand. In the graph that follows, the equilibrium price is P E, which occurs at the intersection of the market supply and demand curves. At this price, Q E is the quantity at the point of equilibrium that will be produced and purchased. Thus, due to the equilibrium of supply and demand, the entire production will be bought, and the market will be cleared. At a higher price, however, such as P 1, the quantity supplied would be greater than the quantity demanded. Consequently, a surplus of output would be present, inducing producers to start cutting back on their output. Likewise, at a price lower than P E, such as P 2, the quantity demanded would exceed the quantity supplied, so that a shortage of output would develop. This would induce producers to begin expanding their output. Thus, P E is the only price that can persist in the marketplace since it is the equilibrium price that leaves neither a surplus nor a shortage of output. P S P 1 P E P 2 D Q E Q The equilibrium price in the market for a particular product can change because of a change in either demand or supply. For example, in the left-hand graph presented below, a shift in demand 2016 Keir Educational Resources 1.5 800-795-5347
has occurred from D 1 to D 2, with the supply curve unchanged. Note, then, that the equilibrium price rises from P 1 to P 2. P S P D P 2 P 1 P 1 P 2 D 1 D 2 S 1 S 2 Q Q In the right-hand graph, on the other hand, a shift in supply has taken place, reflected by a movement of the supply curve from S 1 to S 2. The demand curve is unchanged in this case. Note, then, that the impact of this increase in supply is a reduction of the equilibrium price from P 1 to P 2. Notice in the preceding examples, then, that an increase in demand causes the equilibrium price to rise, whereas an increase in supply causes the equilibrium price to fall. You could draw your own lines to show a decrease in demand or a decrease in supply. You would find that in both of these cases, the impact on price would be the reverse of that shown above. Namely, a decrease in demand will cause the equilibrium price to fall, and a decrease in supply will cause the equilibrium price to rise. Practice Question During the early 1970s, the U.S. experienced a period of stagflation in which production was stagnant, but prices for goods continued to rise due to increased oil prices. Which of the following statements most likely describes the effect on the demand and supply curves caused by stagflation? A. The demand curve moved up to the left, the supply curve was unchanged, so the equilibrium price rose. B. The supply curve shifted up to the right, demand moved down to the left, so equilibrium price rose. C. The demand curve moved down to the left, the supply curve moved down to the right, so the equilibrium price dropped. 2016 Keir Educational Resources 1.6 800-795-5347
D. The supply curve moved up to the left, the demand curve was unchanged, so the equilibrium price rose. Answer: With stagflation, the prices rose so the supply curve moved to the left as in the graph from S 2 to S 1. Fewer goods were demanded at the higher prices, so the equilibrium price moved up the demand curve shown as D from P 2 to P 1. The answer is D. (Selection moves to Monetary Policy.) Advantages of Monetary Policy Monetary policy also has several strengths: Monetary policy can be decided and implemented quickly. Only the Federal Reserve Board is involved, in contrast to the approval needed by Congress and the President to establish fiscal policy. Because monetary policy works through changes in the money supply and interest rates, it comes closer than fiscal policy to being value-free. Changes in the money supply and interest rates do not work through specific programs and taxes, as does fiscal policy, and do not involve the same issues of public goals. The fact that decisions with respect to monetary policy are insulated to a greater extent from political or popular pressures makes monetary policy, in the eyes of some, less likely to be used unwisely in an inflationary way. The tools available for implementing monetary policy especially the open-market purchase and sale of securities can be finely adjusted and reversed quickly, compared with fiscal policy. 2016 Keir Educational Resources 1.7 800-795-5347
KEY SUMMARY 12 1 Monetary and Fiscal Policy Fed Tools of Monetary Policy Setting reserve requirement Raising or lowering discount rate Buying or selling Treasury securities debt Margin requirements Goals of Monetary Policy Gov t. Tools of Fiscal Policy Raising or lowering taxes Increasing or decreasing spending Borrowing or repaying Goals of Fiscal Policy Expand the economy by: Expand the economy by: - Increasing the money supply - Increasing spending - Reducing interest rates - Reducing taxes - Loosening credit Slow the economy by: Slow the economy by: - Shrinking the money supply - Reducing spending - Increasing interest rates - Increasing taxes - Tightening credit Economic Indicators The National Bureau of Economic Research tracks a variety of aggregate measures of economic activity. Several of these are leading indicators, meaning that they tend to give early signals of the future direction of the economy. A few of these leading indicators, which, of course, should be of great interest to investors, are: (a) the average weekly hours of manufacturing production workers, (b) the average weekly new claims for unemployment compensation, (c) building permits for new private housing units, (d) stock prices, and (e) size of the money supply. Other indexes that may serve as leading indicators are those that measure consumer confidence. These types of surveys focus on consumer perceptions of business conditions and of their own financial condition and on their willingness to buy consumer durables, such as cars. Increases in these indexes are positive signs, while decreases are negative signs of the near future. Business Cycles The business cycle is the name economists give to the expansion and contraction of economic activity. The beginning is said to be a trough of the wave, and expansion continues until economic activity reaches a peak and economic activity turns down. In the 2016 Keir Educational Resources 1.8 800-795-5347
U.S., the expansion phase has averaged approximately 4.5 years, and the contraction phase has averaged approximately one year. Peak Real GNP Trough Expansion Recession Expansion Recession Recovery Contraction Recovery Contraction Years The following are some suggested strategies for investing during various stages of the business cycle: From mid-contraction to trough: Inflation and interest rates have reached their peak and are ready to turn downward. Bonds will tend to do well, whereas real estate, gold, and other hard assets will not. Purchase of long-term bonds and preferred stocks should be pursued because lower interest and inflation rates tend to be favorable for these investments. Stock purchases at depressed prices should be considered. From trough to mid-expansion: Inflation and interest rates continue to fall and then level off. Unemployment falls, capacity utilization rises, and capital spending rises. Bonds will do well, but not as well as formerly. Bond purchases should be limited to short-duration securities. Stocks will do well as corporate earnings rise. Small positions in gold and other hard assets should be considered. From mid-expansion to peak: Inflation and interest rates rise. Labor productivity falls, and capital utilization nears full capacity. The Fed tightens up on the money supply to head off further inflation. Bonds, preferred stocks, and other interestsensitive securities should be sold. Performance of common stocks, in general, will be mediocre at best. Hard assets like real estate, gold, and other natural resources tend to do well. Money market securities also are advisable in this environment, 2016 Keir Educational Resources 1.9 800-795-5347
as are common stocks in defensive industries, such as food and drug stocks, which tend to hold up well in a bear market. Peak to mid-contraction: Inflation and interest rates are high, and the economy begins slowing down. Prices and interest rates fall, but only slowly. Profits shrink, capital spending is postponed, and unemployment rises. New commitments in hard assets should be avoided since these have already peaked. Money market funds and short-term securities make sense until the future direction of the economy becomes clearer. Practice Question If consumer and business spending are high, the stock market and inflation are rising, and unemployment claims are falling, what action is the Fed likely to take? A. Sell Treasuries in the open market B. An easy money policy C. Reduce government borrowing D. Reduce the discount rate Answer: The economic conditions suggest that the business cycle is expanding and may be near a peak, so the Fed is likely to adopt a tight money policy to restrain inflation. The tight money policy may involve selling Treasury securities in the open market, raising the discount rate, or raising reserve requirements. The Fed does not set the level of government borrowing. The answer is A. 2016 Keir Educational Resources 1.10 800-795-5347
* Fed tightens money supply * Sell bonds and preferred stock * Real estate, gold, hard assets do well *Stocks show mediocre performance * Prices and interest rates will slowly start to fall; capital spending is postponed * Money market & ST securities can hold assets until the future direction of the economy is known * Avoid buying hard assets (already peaked) *Sell stocks *Unemployment falls, capital spending rises * Buy ST bonds and common stocks * Consider buying real estate, gold, hard assets * Fed expands money supply * Buy LT bonds and preferred stocks * Sell real estate, gold, hard assets THINK LIKE A PLANNER SM Job Task Domain 7 (Monitoring the Recommendations) questions may describe current economic conditions, Federal Reserve Board actions, Fiscal Policy changes, or various leading indicators and ask the planner what changes need to be made to the plan based on this information. Questions may address investments, as described above, but could also affect other areas of the plan such as retirement withdrawal rates for clients in the distribution phase of 2016 Keir Educational Resources 1.11 800-795-5347
retirement. Clients may need to adjust their lifestyle and spending during some years of retirement to compensate for periods of lower-than-expected investment returns due to changes in the economic cycle. Continuing higher withdrawal rates through extended periods of low returns may require clients to deplete principal more quickly than anticipated. The planner will need to ensure that these clients understand the consequence of doing so, and encourage the clients to make adjustments as needed. 2016 Keir Educational Resources 1.12 800-795-5347
APPLICATION QUESTIONS 1. During a period in which inflation averages 6 percent per year, which of the following groups will be hurt? (1) Lenders of funds at a fixed rate of interest (2) Borrowers of funds at a fixed rate of interest (3) Recipients of Social Security retirement benefits (4) Recipients of benefits under a defined-benefit pension plan A. (1) only B. (3) only C. (1) and (4) only D. (2) and (4) only E. (1), (3), and (4) 2. Assume that at the start of a particular year, the CPI stood at 111, and that at the end of the year, it stood at 116. In this case, which of the following was the annual rate of inflation? A. 4.1% B. 4.5% C. 4.8% D. 5.0% E. 5.3% 3. Bonds of the GHI Corporation were recently issued to yield a 7.3% rate of return. Bonds of the JKL Corporation were issued on the same day to yield a 6.8% rate of return. Which of the following factors may have accounted for this difference? (1) Differences in the risk-free rate of return (2) A shorter time to maturity for the GHI bonds (3) A lower degree of default risk for the JKL bonds (4) The presence of collateral underlying the GHI bonds A. (1) only B. (3) only C. (2) and (4) only D. (1), (2), and (4) only E. (2), (3), and (4) only 2016 Keir Educational Resources 1.13 800-795-5347
ANSWERS AND EXPLANATIONS 1. C is the answer. (2) is incorrect because borrowers will repay with cheaper dollars than they received. (3) is incorrect because Social Security retirement benefits are indexed each year for inflation. 2. B is the answer. The CPI rose by 5 points from a starting point of 111. 5 111 = 4.5%. 3. B is the answer. (1) is incorrect because the risk-free rate at any point in time is the same for the two bond issues. (2) is incorrect because a shorter maturity would normally produce a lower yield for the GHI bond issue. (4) is incorrect because the presence of collateral would normally produce a lower yield for the GHI bonds. 2016 Keir Educational Resources 1.14 800-795-5347