Essential Flashcards for Chapter 8 Success
Key Investment Terms
Asset Allocation The process of dividing investments among different asset categories (stocks, bonds, cash) to manage risk according to goals, risk tolerance, and time horizon.
Bull Market A period of rising stock prices, typically defined as an increase of 20% or more from recent lows.
Bear Market A period of falling stock prices, typically defined as a decline of 20% or more from recent highs.
Capital Gain The profit realized when an investment is sold for more than its purchase price.
Compound Interest Interest calculated on both the initial principal and previously accumulated interest; “interest on interest.”
Diversification The strategy of spreading investments across various assets to reduce risk.
Dividend A distribution of a company’s earnings to shareholders, usually paid quarterly.
Dollar-Cost Averaging Investing a fixed amount at regular intervals regardless of market conditions.
Exchange-Traded Fund (ETF) A marketable security that tracks an index, commodity, or basket of assets but trades like a stock on an exchange.
Index Fund A type of mutual fund that aims to track the returns of a market index (e.g., S&P 500).
Liquidity The ease with which an asset can be converted to cash without affecting its price.
Market Capitalization The total dollar value of a company’s outstanding shares, calculated by multiplying share price by number of shares.
Mutual Fund An investment vehicle that pools money from many investors to purchase securities.
Portfolio The collection of investments held by an individual or organization.
Rate of Return The gain or loss on an investment over a specified period, expressed as a percentage of the initial investment.
Rebalancing The process of realigning the weightings of a portfolio by periodically buying or selling assets to maintain the original asset allocation.
Risk Tolerance An investor’s ability and willingness to endure market volatility and potential loss.
Securities Financial instruments that hold value and can be traded between parties.
Time Horizon The expected length of time over which an investment will be held before it’s needed.
Volatility A statistical measure of the dispersion of returns for a given security or market index.
Investment Vehicles
Bond A debt security where an investor loans money to an entity for a defined period at a fixed interest rate.
Certificate of Deposit (CD) A time deposit offered by banks with a specific, fixed term and interest rate.
Common Stock A security representing ownership in a corporation, providing voting rights and potential dividends.
Corporate Bond A debt security issued by a corporation to raise capital.
Government Bond A debt security issued by a government to support government spending.
Money Market Account A type of savings account that usually pays higher interest than regular savings accounts.
Municipal Bond A bond issued by a state, municipality, or county to finance public projects.
Preferred Stock A class of stock that pays dividends at a specified rate and has preference over common stock in dividend payments and asset liquidation.
Real Estate Investment Trust (REIT) A company that owns, operates, or finances income-producing real estate.
Treasury Bill A short-term U.S. government debt obligation with a maturity of less than one year.
Formulas to Memorize
Simple Interest I = P × r × t (Interest = Principal × rate × time)
Compound Interest A = P(1 + r)^t (Final amount = Principal × (1 + rate)^time)
Present Value PV = FV / (1 + r)^t (Present Value = Future Value / (1 + rate)^time)
Future Value FV = PV(1 + r)^t (Future Value = Present Value × (1 + rate)^time)
Dividend Yield Dividend Yield = Annual Dividends per Share / Price per Share
Price-to-Earnings Ratio (P/E) P/E Ratio = Price per Share / Earnings per Share
Rate of Return ROR = [(Current Value – Initial Value) + Income] / Initial Value
Quick Concept Review
Risk-Return Relationship
Concept: Higher potential returns are generally associated with higher levels of risk.
Key Points:
- Low risk: Cash equivalents, high-grade bonds (lower returns)
- Medium risk: Balanced funds, blue-chip stocks
- High risk: Growth stocks, emerging markets (higher potential returns)
Test Tip: Questions often ask you to identify where specific investments fall on the risk-return spectrum.
Time Horizon and Investment Strategy
Concept: Appropriate investment strategies vary based on the time available before funds are needed.
Key Points:
- Short-term (0-3 years): Focus on capital preservation and liquidity
- Medium-term (3-10 years): Moderate growth with reduced volatility
- Long-term (10+ years): Focus on growth, can withstand higher volatility
Test Tip: Expect scenario questions asking you to recommend appropriate investments for people with different time horizons.
Diversification Benefits
Concept: Spreading investments across different asset classes reduces overall portfolio risk.
Key Points:
- Diversification works because different investments respond differently to market conditions
- Properly diversified portfolios include multiple asset classes, industries, and geographic regions
- Correlation measures how investments move in relation to each other
Test Tip: Look for questions asking about the primary purpose of diversification (risk reduction, not return enhancement).
Types of Investment Risk
Concept: Different investments face various types of risk.
Key Points:
- Market risk: Affects all investments in a particular market
- Interest rate risk: The risk that changes in interest rates will affect investment values
- Inflation risk: The possibility that investment returns won’t keep pace with inflation
- Credit/Default risk: The risk that a borrower will not repay their debt
- Liquidity risk: The difficulty of selling an investment quickly without loss
Test Tip: Questions may ask you to identify which risk is most relevant to a specific investment or scenario.
Practice Questions
Multiple Choice
- Which of the following investments typically has the HIGHEST potential return and risk? A) Treasury bonds B) Certificate of deposit C) Blue-chip stocks D) Small-cap growth stocks
Answer: D) Small-cap growth stocks - What is the primary purpose of diversification in an investment portfolio? A) To maximize returns B) To reduce risk C) To eliminate taxes D) To increase liquidity
Answer: B) To reduce risk - A 25-year-old saving for retirement would MOST likely benefit from which asset allocation? A) 20% stocks, 70% bonds, 10% cash B) 50% stocks, 40% bonds, 10% cash C) 80% stocks, 15% bonds, 5% cash D) 40% stocks, 40% bonds, 20% cash
Answer: C) 80% stocks, 15% bonds, 5% cash - An investor who needs their money in 1-2 years should PRIMARILY focus on: A) Growth potential B) Capital preservation and liquidity C) Dividend income D) Tax advantages
Answer: B) Capital preservation and liquidity - Which investment vehicle is designed to track the performance of a market index? A) Actively managed mutual fund B) Individual corporate bonds C) Index fund D) Certificate of deposit
Answer: C) Index fund
Calculation Problems
- If you invest $5,000 at 6% annual interest compounded annually, how much will you have after 5 years?
Using the compound interest formula: A = P(1 + r)^t A = $5,000(1 + 0.06)^5 A = $5,000(1.3382) A = $6,691 - A stock currently priced at $45 pays annual dividends of $1.80. What is its dividend yield?
Dividend Yield = Annual Dividends per Share / Price per Share Dividend Yield = $1.80 / $45 Dividend Yield = 0.04 or 4% - If you need $100,000 in 20 years and expect to earn 7% annually, how much do you need to invest today?
Using the present value formula: PV = FV / (1 + r)^t PV = $100,000 / (1 + 0.07)^20 PV = $100,000 / 3.87 PV = $25,842
Quick Test-Taking Tips
- For terminology questions:
- Pay close attention to similar-sounding terms (e.g., yield vs. return)
- Identify keywords in the question that match specific definitions
- When in doubt, eliminate obviously wrong answers
- For calculation questions:
- Write down the formula before plugging in numbers
- Double-check your decimal points in calculations
- Verify that your answer makes logical sense (e.g., interest rates as percentages)
- For scenario-based questions:
- Identify the key factors (age, goals, time horizon, risk tolerance)
- Remember the fundamental relationship between risk and return
- Consider how diversification affects the scenario
- Time management:
- Answer easy questions first to build confidence
- Don’t spend more than 1-2 minutes on calculation questions
- If stuck, mark the question and return to it later
Last-Minute Review Strategy
If you only have 30 minutes to study, focus on:
- Memorizing the key formulas (compound interest, present/future value)
- Reviewing the risk-return spectrum and where major investments fall on it
- Understanding how time horizon affects investment strategy
- Knowing the definition of key terms (diversification, asset allocation, rebalancing)
- Practicing 2-3 quick calculation problems
If you have 5 minutes before the test:
- Review the formulas one last time
- Remember the relationship between risk and return
- Take a deep breath and focus on applying what you know
After the Test: Applying Chapter 8 Knowledge
Understanding investment basics isn’t just about passing a test—these concepts will serve you throughout your financial life. Consider taking these steps after completing Chapter 8:
- Start tracking real market indices to understand market behavior
- Research investment platforms that allow small initial deposits
- Create a sample paper portfolio to practice investment selection
- Set financial goals with specific time horizons to guide your future investment decisions
Good luck on your Chapter 8 test!
This Quizlet-style study guide provides general information about typical Personal Finance Chapter 8 content on investing basics. Your specific course may cover additional or different material, so always prioritize your instructor’s guidance and assigned textbook.