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Quiz on
Long-Term Investing

Investors in the financial markets are generally either traders or buy-and-holders.  This TRUE-FALSE quiz of 15 questions is aimed at the long term investor who is also interested in accumulating savings.

Drag the mouse pointer over the bracket to see the answer.

1. For holding periods of 20 years or more, the return on a diversified portfolio of large capitalization stocks has always exceeded the inflation rate.  [True*]

The average annualized return over the long term on the S&P 500 stock index, with dividends reinvested, has exceeded the inflation rate by nearly seven percentage points.  For long-term corporate bonds, that margin is only about two percentage points.

2. The S&P500 index is a measure of the average price of the 500 stocks comprising the index.  [False]

The S&P500 index varies in direct proportion to the total market value of its 500 component stocks.  An S&P500 index mutual fund is basically an investment in the largest 45 corporations because they comprise over one-half of the total value of those 500 stocks.

3. The total return quoted on a mutual fund is a statement of its expected future performance over the specified period, with dividends reinvested.  [False]

The quoted total return does assume dividends are reinvested, but it is only a record of past performance. It is not a reliable predictor of future performance, particularly in managed funds where the effectiveness of investment styles continually ebb and flow.

4. The total return on an S&P500 index mutual fund has usually exceeded the return on most managed stock mutual funds.  [True*]

Although index funds are never the top performers, the best ones usually beat the return on about two-thirds of managed funds because of lower turnover and thus lower brokerage expenses, the absence of research expenses, and lower management fees.

5. Stock mutual funds with a narrow focus like sector funds have lower price volatility than broad-based funds.  [False]

The narrower the focus, the greater the volatility.  A broad-based fund will track the market average more closely than will a sector fund, and will have less price volatility due to better diversification.  However the potential for gain is lower, at least in the short term.

6. Short maturity bonds have lower price volatility than long maturity bonds.  [True*]

The market price of existing long maturity bonds is influenced far more by the effect of changes in interest rates and inflation expectations.

7. For a given maturity, high coupon bonds have lower price volatility than low coupon bonds.  [True*]

A higher coupon provides greater income up front which helps compensate for the effects of interest rate fluctuations on the market price, and thus results in lower price volatility.

8. Except for management fees, owning a bond mutual fund is financially equivalent to owning a share of the bonds themselves.  [False]

Unlike individual bonds, a bond mutual fund has no maturity date, and thus no date-certain market value.  The bonds must be continually replaced to maintain the advertised average maturity of the fund, which adds transaction costs.

9. When interest rates rise, the market value of existing bonds and bond mutual funds rise.  [False]

When interest rates rise, the coupons on existing bonds become less attractive relative to those available on new issues of the same maturity, causing the market price of existing bonds to fall.

10. Individuals can buy newly issued Treasury securities directly from the Treasury without commissions or fees.  [True*]

The Treasury Direct system now enables individuals to buy newly issued Treasury securities without fees directly from the Treasury rather than through a bank or securities dealer.  The yield is exactly the same as that received by the securities dealers who make the market.

11. A T-note ladder is a set of Treasury notes maturing at about equal intervals and rolled over (reinvested) as they mature.  [True*]

Treasury notes of 2- or 5-year maturity can be bought or reinvested monthly to create the equivalent of a risk-free short-term Treasury bond fund, which is free of service charges and management fees.

12. In addition to ordinary notes of up to 10-year maturity, the Treasury issues inflation-indexed securities.  [True*]

The Treasury now issues two inflation-indexed securities: a 10-year note known as TIPS for Treasury Inflation-Protected Securities, and a 30-year accrual type security known as the Series I Savings Bond.

13. The quoted yield to maturity on a bond assumes that the bond is held to maturity and all coupon payments are reinvested.  [True*]

The assumed reinvestment rate is the yield to maturity itself, not the coupon rate.  If the coupon payments are not reinvested, the return will be less than the quoted yield.

14. The yield to maturity on a bond is an accurate measure of the return if held to maturity.  [False]

Since a coupon payment can almost never be reinvested at exactly the yield to maturity, that rate is an approximation of the actual return. One exception is the yield on zero coupon bonds because there are no coupon payments to reinvest.

15. The coupon earnings on state and local municipal bonds are subject only to federal income tax.  [False]

The coupon earnings on munis are free of federal income tax.  For residents of the state where issued, they are also free of state income tax. Coupon earnings on Treasury securities are subject to federal income tax, but free of state income tax.

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