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CFP Investment Planning Practice Questions

Official outline
CFP Board Principal Knowledge Topics (2021 practice analysis)
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6
Updated
Nov 3, 2026
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17%

  1. Question 1, easy

    A stock has a beta of 1.3. This means the stock's returns are expected to be:

    • A.Uncorrelated with the overall market
    • B.About 1.3 times as volatile as the overall market due to systematic risk
    • C.30% less volatile than the risk-free rate
    • D.A measure of the stock's total risk, including company-specific risk and market risk
    Show answer and explanationHide answer

    Correct answer: B. About 1.3 times as volatile as the overall market due to systematic risk

    Beta measures a security's sensitivity to overall market movements. A beta of 1.3 implies the stock tends to move about 1.3 times as much as the market in the same direction, reflecting greater-than-market systematic risk. Beta says nothing about correlation being zero, has no direct relationship to the risk-free rate, and specifically excludes unsystematic (company-specific) risk, which is measured instead by the residual/unexplained variance or captured in standard deviation.

    • A. Wrong. A beta of 1.3 indicates a strong positive relationship with the market, the opposite of being uncorrelated.
    • B. Correct. Beta measures sensitivity to systematic (market) risk, so a beta of 1.3 implies returns that move about 30% more than the market in the same direction.
    • C. Wrong. Beta relates a stock's volatility to the overall market's movement, not to the risk-free rate, and 1.3 indicates greater, not lesser, volatility.
    • D. Wrong. Beta captures only systematic (market) risk; it excludes unsystematic, company-specific risk, so it is not a measure of total risk, which standard deviation of total returns would capture.

  2. Question 2, medium

    An investor commits to investing a fixed dollar amount into a mutual fund every month, regardless of share price. Which outcome is a direct mathematical result of this dollar-cost averaging strategy, assuming the share price fluctuates over the period?

    • A.The investor is assured of a profit on the shares purchased, because a lower average cost per share means the final price must exceed that cost
    • B.The investor removes exposure to market declines on the shares purchased, because spreading purchases over time protects the account balance from falling prices, even in a prolonged falling market
    • C.The investor buys the same number of shares each period, so the average cost per share equals the simple average of the prices paid across the periods
    • D.The investor's average cost per share will generally be lower than the simple average of the share prices paid, because more shares are purchased when prices are lower
    Show answer and explanationHide answer

    Correct answer: D. The investor's average cost per share will generally be lower than the simple average of the share prices paid, because more shares are purchased when prices are lower

    Because a fixed dollar amount buys more shares when prices are low and fewer shares when prices are high, the resulting average cost per share is mathematically lower than or equal to the simple arithmetic average of the prices paid across periods. It does not guarantee a profit or eliminate market risk.

    • A. Wrong. A lower average cost does not assure a profit; if the price at the end of the period is below the average cost, the investor still has a loss.
    • B. Dollar-cost averaging manages timing risk but does not eliminate market risk. The investor is still fully exposed to price declines, including in a prolonged falling market.
    • C. Wrong. A fixed dollar amount buys more shares when prices are low and fewer when prices are high, so the share count changes each period and the average cost falls below the simple average price.
    • D. Correct. Because a fixed dollar amount buys more shares when prices are low and fewer when prices are high, the resulting average cost per share is generally below the simple average of the prices paid.

  3. Question 3, medium

    Two retirees experience the same 20-year arithmetic average return. One has steep losses in the first two years while withdrawing a fixed inflation-adjusted amount; the other has losses late in retirement. What is the key risk to evaluate?

    • A.Inflation risk is the main driver, because inflation-adjusted withdrawals erode purchasing power more for the retiree who suffers early losses.
    • B.Late-retirement losses are more damaging because they apply to a larger accumulated balance and leave less time to adjust spending.
    • C.Volatility drag is the main driver, because the retiree with early losses earns a lower geometric return despite the matching arithmetic average.
    • D.Early negative returns combined with withdrawals can irreversibly deplete capital before recovery.
    Show answer and explanationHide answer

    Correct answer: D. Early negative returns combined with withdrawals can irreversibly deplete capital before recovery.

    Withdrawals during early drawdowns force sales at depressed prices, reducing the capital left to compound in a recovery. Identical average returns do not produce identical outcomes when withdrawals are taken.

    • A. Both retirees withdraw the same inflation-adjusted amounts, so inflation affects them identically. It cannot explain why the outcomes differ; the order of returns relative to the withdrawals does.
    • B. This reverses the effect. Early in the withdrawal phase, losses hit the full balance while withdrawals continue, so shares are sold at depressed prices and the lost capital cannot participate in the recovery. Late losses hit a balance that has already had time to grow and that must support fewer remaining years of spending. This is sequence-of-returns risk, and it is worst early.
    • C. Both retirees earn the same set of annual returns in a different order, so their geometric returns are identical. The gap in outcomes comes from withdrawals interacting with the order of returns, not from a difference in compounded return.
    • D. Correct: early losses plus withdrawals can deplete capital before markets recover.

  4. Question 4, hard

    A retiree holds a large position in long-term fixed-rate bonds and short-term CDs as her primary source of retirement income over an expected 20-year retirement. Which risk is she most exposed to, and which strategy is generally best suited to help mitigate it?

    • A.Reinvestment risk; mitigated by shifting the portfolio into zero-coupon bonds that do not pay periodic interest requiring reinvestment
    • B.Liquidity risk; mitigated by extending the portfolio into additional long-term CDs that pay higher stated interest rates over time
    • C.Default risk; mitigated by moving the entire portfolio into short-term U.S. Treasury bills backed by the full faith and credit of the federal government, which removes issuer failure risk
    • D.Purchasing power (inflation) risk; mitigated by including growth-oriented assets such as equities or inflation-linked securities (e.g., TIPS) in the portfolio
    Show answer and explanationHide answer

    Correct answer: D. Purchasing power (inflation) risk; mitigated by including growth-oriented assets such as equities or inflation-linked securities (e.g., TIPS) in the portfolio

    A portfolio concentrated in fixed-rate instruments with income that does not adjust for inflation exposes a long-horizon retiree to purchasing power risk. The erosion of real income and principal value over time as the cost of living rises. Over a 20-year retirement, even modest inflation compounds substantially. Mitigation generally requires an allocation to assets whose returns can outpace inflation over time, such as equities, or securities explicitly indexed to inflation, such as TIPS. Reinvestment and default risk are real but secondary concerns here; more long-term CDs would actually worsen purchasing power risk, not improve liquidity in a meaningful way for this concern.

    • A. Wrong. Reinvestment risk is not the main threat over a 20-year retirement funded by fixed-rate holdings; the bigger danger is inflation eroding purchasing power, and zero-coupon bonds do nothing to address that.
    • B. Wrong. Liquidity risk is not the central issue here, and adding longer-term CDs at higher stated rates would not protect purchasing power over two decades.
    • C. Wrong. Default risk isn't the primary concern in this scenario, and shifting entirely to T-bills, even though they carry little issuer failure risk, would worsen, not fix, the inflation exposure.
    • D. Correct. A portfolio concentrated in fixed-rate bonds and short-term CDs is highly exposed to purchasing power (inflation) risk over a long retirement, best mitigated by adding growth assets like equities or inflation-linked securities such as TIPS.

  5. Question 5, hard

    Portfolio X has an average return of 12% and a standard deviation of 15%. Portfolio Y has an average return of 10% and a standard deviation of 8%. The risk-free rate is 2% for both. Which portfolio has the better risk-adjusted performance as measured by the Sharpe ratio?

    • A.Portfolio Y, because its Sharpe ratio of approximately 1.00 exceeds Portfolio X's Sharpe ratio of approximately 0.67
    • B.Portfolio X, because its raw return is higher
    • C.Portfolio X, because its Sharpe ratio of approximately 0.80 exceeds Portfolio Y's
    • D.The two portfolios are equal on a risk-adjusted basis
    Show answer and explanationHide answer

    Correct answer: A. Portfolio Y, because its Sharpe ratio of approximately 1.00 exceeds Portfolio X's Sharpe ratio of approximately 0.67

    Sharpe ratio X = (12% − 2%) / 15% ≈ 0.67. Sharpe ratio Y = (10% − 2%) / 8% ≈ 1.00. Despite the lower raw return, Portfolio Y delivers more return per unit of total risk and is superior on a risk-adjusted basis.

    • A. Correct. Sharpe ratio = (return − risk-free rate) ÷ standard deviation. Portfolio Y: (10% − 2%) ÷ 8% = 1.00; Portfolio X: (12% − 2%) ÷ 15% ≈ 0.67. Portfolio Y's higher Sharpe ratio means better risk-adjusted performance despite its lower raw return.
    • B. Comparing raw returns ignores risk entirely; the Sharpe ratio exists precisely because higher raw return doesn't mean better risk-adjusted performance, and Portfolio X's higher volatility more than offsets its return advantage.
    • C. This reverses the actual calculation. Portfolio X's Sharpe ratio is approximately 0.67, not 0.80, and it is lower than Portfolio Y's, not higher.
    • D. The two portfolios are not equal; their Sharpe ratios (≈0.67 vs. 1.00) differ meaningfully, with Portfolio Y clearly superior on a risk-adjusted basis.

  6. Question 6, medium

    An investor holds a portfolio of 15 stocks, all within the same industry sector, that are highly positively correlated with one another. Which type of risk remains largely unreduced in this portfolio despite holding multiple securities?

    • A.Systematic risk only, because holding 15 different stocks is enough to eliminate the company-specific and industry-specific risk
    • B.Unsystematic risk only, because holding 15 different stocks is enough to eliminate the market-wide risk and leave the company-specific risk
    • C.Both systematic risk and a substantial amount of unsystematic (company/industry-specific) risk, because diversification benefit depends on low correlation among holdings
    • D.Neither systematic nor unsystematic risk, because 15 holdings is generally enough to achieve full diversification of any portfolio
    Show answer and explanationHide answer

    Correct answer: C. Both systematic risk and a substantial amount of unsystematic (company/industry-specific) risk, because diversification benefit depends on low correlation among holdings

    Diversification reduces unsystematic (company- and industry-specific) risk primarily by combining securities with low or negative correlation to one another. Simply holding many securities is not sufficient if those securities are all highly correlated (as with a single-sector portfolio). Much of the unsystematic risk remains. Systematic (market) risk, by contrast, can never be eliminated through diversification under any circumstances.

    • A. Incorrect. It treats the number of holdings as what matters. The 15 stocks are highly correlated and all in one sector, so they tend to move together. A large share of company- and industry-specific risk therefore remains, and it cannot be dismissed as eliminated.
    • B. Incorrect. It reverses the basic principle. Market-wide systematic risk cannot be diversified away by adding securities, so holding 15 stocks does not remove it. Unsystematic risk is not the only risk left.
    • C. Correct. High correlation among holdings leaves substantial unsystematic risk in place, alongside irreducible systematic risk.
    • D. Incorrect. The 'about 15 stocks is enough' rule of thumb assumes holdings with low correlation across different industries. With 15 highly correlated stocks in one sector, much unsystematic risk persists. Systematic risk is never diversified away in any case.

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