Study guide
At 30 percent of the exam, about 39 scored questions, this chapter is where product knowledge meets real clients. It covers who the client is, how to build and manage a suitable portfolio, and the tax, retirement, ownership, and trading machinery that surrounds every recommendation.
Types of Clients and Building the Client Profile
Recommendations start with knowing who the client is legally. Individuals and sole proprietorships report business income on the owner's personal return and carry unlimited personal liability. General partnerships give every partner management rights and unlimited liability. Limited partnerships have a general partner who manages with unlimited liability and limited partners who are passive with losses capped at their investment. Limited liability companies combine liability protection with pass-through tax flexibility. C corporations are separate taxpayers whose dividends are taxed again to shareholders (double taxation), while S corporations pass income through but are limited to 100 shareholders, one class of stock, and generally U.S. persons. Trusts and estates are fiduciary accounts governed by the trust document or will; revocable (grantor) trusts are taxed to the grantor, while irrevocable trusts are separate taxpayers with compressed brackets. Foundations and charities invest around spending policies and long horizons. The client profile then fills in the person behind the entity: financial goals; current and future finances captured in a cash flow statement and personal balance sheet; existing investments and their cost basis; tax situation; expected Social Security and pension income; risk tolerance (willingness to take risk) versus capacity (financial ability to absorb loss); time horizon and liquidity needs. Nonfinancial considerations count too: environmental, social, governance, or religious values; investment experience; life stage and events; and behavioral finance biases like loss aversion, overconfidence, recency, and anchoring. Data gathering runs through client identification, questionnaires, and interviews, and the profile must be kept current. The governing principle is suitability: an adviser needs a reasonable basis, grounded in the whole picture, before recommending anything.
Capital Market Theory and Portfolio Strategies, Styles, and Techniques
Modern Portfolio Theory holds that combining assets with less-than-perfect correlation reduces portfolio risk, and the efficient frontier maps the portfolios offering the highest expected return at each level of risk. The Capital Asset Pricing Model prices expected return as the risk-free rate plus beta times the market risk premium: with a 3 percent risk-free rate, a 9 percent expected market return, and a beta of 1.2, expected return is 3 + 1.2 x (9 - 3) = 10.2 percent. The Efficient Market Hypothesis comes in three forms: weak form says prices already reflect all past trading data, making technical analysis useless; semi-strong says all public information is priced in, making fundamental analysis useless too; strong form says even inside information is reflected. Belief in efficient markets supports passive, low-cost indexing; active management bets on finding mispricings. Strategic asset allocation sets a long-term target mix based on objectives and risk tolerance, then rebalances periodically, which forces selling recent winners and buying laggards. Tactical asset allocation makes short-term shifts to exploit market views, a cousin of market timing. Management styles include growth (high price-to-earnings, accelerating earnings, low dividends), value (out-of-favor stocks at low multiples), income (dividends and interest), and capital appreciation. Techniques include diversification; sector rotation (shifting industries as the business cycle turns); dollar-cost averaging, which invests a fixed dollar amount at regular intervals so more shares are bought when prices are low, producing an average cost below the average price in a fluctuating market without guaranteeing a profit; buying or writing options for hedging or income; leverage through margin, which magnifies gains and losses; volatility management; and inverse strategies for hedging. High-frequency trading is algorithmic trading at extreme speed, tested mostly as a definition.
Tax Considerations: Individuals, Entities, and Wealth Transfer
Individual income tax runs on marginal brackets: the marginal rate applies to the next dollar earned, while the effective rate is the average across all income. Capital gains depend on holding period: more than one year is long-term, taxed at preferential 0, 15, or 20 percent rates; one year or less is short-term, taxed as ordinary income. Qualified dividends, generally from U.S. and many established foreign corporations when holding period rules are met, get the same preferential rates; nonqualified dividends, including most REIT distributions, are ordinary income. Tax basis is cost plus reinvested distributions. Two transfer rules are heavily tested: gifted assets carry over the donor's basis and holding period, while inherited assets receive a step-up to date-of-death value and are automatically long-term. The alternative minimum tax is a parallel calculation; preference items include the ISO exercise spread and interest on private-activity municipal bonds. Retirement distributions of pre-tax money are ordinary income, required minimum distributions begin at age 73, and shortfalls draw a 25 percent penalty (10 percent if corrected promptly). Higher income can also raise Medicare premiums through income-related monthly adjustment amounts (IRMAA). Entity taxation: C corporations pay tax and their dividends are taxed again to shareholders; S corporations, partnerships, LLCs, and MLPs pass income through to owners on Schedule K-1; REITs deduct dividends paid so shareholders bear the tax. Wealth transfer basics for 2026: the annual gift exclusion is $19,000 per recipient ($38,000 with spousal gift-splitting); marital and charitable transfers are unlimited; and the unified lifetime estate and gift exemption is $15 million per person, portable between spouses for roughly $30 million per couple. Gifts above the exclusion consume exemption through the unified credit rather than triggering immediate tax.
Retirement Plans, ERISA, and Tax-Advantaged Accounts
Traditional IRAs offer possibly deductible contributions (phase-outs apply if covered by a workplace plan), tax-deferred growth, ordinary-income taxation of withdrawals, a 10 percent penalty before 59 1/2 with exceptions (death, disability, first home up to $10,000, higher education), and RMDs at 73. Roth IRAs take after-tax money, impose income limits on contributions, deliver tax-free qualified withdrawals after five years and age 59 1/2, and have no lifetime RMDs. The 2026 IRA limit is $7,500 plus a $1,100 catch-up at 50. Employer plans: 401(k) elective deferrals are $24,500 in 2026 plus an $8,000 catch-up at 50 ($11,250 for ages 60 to 63); 403(b) plans serve schools and 501(c)(3) nonprofits; 457 plans serve government employees, and governmental 457 withdrawals escape the 10 percent early-withdrawal penalty; SIMPLE IRAs ($17,000 in 2026) require employer contributions; SEP IRAs are employer-funded and simple for the self-employed; solo 401(k)s, traditional or Roth, fit owner-only businesses. Defined benefit plans promise a formula pension, put investment risk on the employer, and favor older, highly paid owners; defined contribution plans put risk on the employee. Nonqualified deferred compensation is an unfunded promise that may discriminate among employees but sits exposed to employer creditors. ERISA governs private-sector plans: fiduciaries must act solely in participants' interests with prudence and diversification; an investment policy statement documents objectives and selection criteria; a qualified default investment alternative (QDIA), such as a target-date fund, protects fiduciaries when auto-enrolled participants make no election; self-dealing and loans between the plan and parties in interest are prohibited transactions. Also know 529 plans (tax-free qualified education withdrawals, K-12 expenses up to $20,000 per year starting in 2026, five-year gift front-loading), Coverdell ESAs ($2,000 annual cap, income limits), UTMA/UGMA custodial accounts (irrevocable gifts under the minor's Social Security number, kiddie tax), and HSAs (require a high-deductible health plan; triple tax advantage; 2026 limits $4,400 self-only and $8,750 family plus $1,000 catch-up at 55).
Account Ownership, Trading Mechanics, and Measuring Performance
Ownership form controls what happens at death. Joint tenants with rights of survivorship (JTWROS) hold equal interests, and the survivor absorbs a decedent's share outside probate. Tenants in common (TIC) may hold unequal shares, and a decedent's share passes through the estate by will. Tenancy by the entirety is a spousal form with creditor protection; community property states treat marital earnings as jointly owned. Transfer-on-death and pay-on-death registrations bypass probate, and beneficiary designations override the will, so review them after divorce; per stirpes sends a deceased beneficiary's share down to that person's descendants. A qualified domestic relations order divides qualified plan assets in divorce without the early-withdrawal penalty, and donor-advised funds give an immediate charitable deduction with grants recommended over time. Trading vocabulary: the bid is the highest price buyers will pay (a client sells at the bid), the ask or offer is the lowest sellers will take, and the spread between them compensates dealers. Market orders guarantee execution but not price; limit orders guarantee price but not execution; stop orders become market orders once the trigger price trades. Short sellers borrow and sell, profiting from declines but facing unlimited loss, and must use margin accounts (Regulation T initial margin is 50 percent). In a principal trade the dealer sells from inventory for a markup; in an agency trade the broker matches parties for a commission, never both on one trade. Introducing broker-dealers take orders while clearing firms custody assets and settle; payment for order flow must be disclosed; advisers owe clients best execution. Performance measures: total return combines income and appreciation; real return subtracts inflation; time-weighted return isolates manager skill by ignoring cash flows, while dollar-weighted (internal rate of return) reflects the investor's actual experience including deposits and withdrawals; current yield is annual income over current price; and every comparison needs a benchmark that matches the portfolio's style.
Key terms
- Suitability
- — The requirement that every recommendation have a reasonable basis grounded in the client's objectives, finances, risk tolerance, and time horizon.
- Capital Asset Pricing Model (CAPM)
- — A model setting expected return equal to the risk-free rate plus beta times the market risk premium.
- Efficient Market Hypothesis
- — The theory that prices reflect available information, in weak, semi-strong, and strong forms that progressively negate technical, fundamental, and insider analysis.
- Strategic asset allocation
- — Setting a long-term target asset mix based on the client profile and rebalancing back to it periodically.
- Dollar-cost averaging
- — Investing a fixed dollar amount at regular intervals, producing an average cost per share below the average price in a fluctuating market.
- Step-up in basis
- — The adjustment of an inherited asset's cost basis to its date-of-death value, with the holding period automatically long-term.
- Required minimum distribution (RMD)
- — The mandatory annual withdrawal from traditional retirement accounts beginning at age 73.
- Qualified default investment alternative (QDIA)
- — A default investment, such as a target-date fund, that shields plan fiduciaries when auto-enrolled participants make no election.
- JTWROS
- — Joint ownership with equal interests in which a deceased owner's share passes automatically to the survivor outside probate.
- UTMA/UGMA account
- — A custodial account holding irrevocable gifts managed for a minor until majority and taxed under the minor's Social Security number.
- Time-weighted return
- — A return measure that removes the effect of client cash flows and therefore isolates the manager's performance.
- Dollar-weighted return
- — The internal rate of return of an investor's actual cash flows, reflecting the timing of deposits and withdrawals.
Exam tips
- Gifted versus inherited property is a classic pairing: gifts carry over the donor's basis and holding period, while inheritances get a stepped-up basis and are automatically long-term.
- Time-weighted return grades the manager; dollar-weighted return describes the investor's actual experience. Read the question stem carefully to see which one is being asked for.
- When a question offers a specific product but the client profile is incomplete, the best answer is almost always to gather more information first. Suitability beats performance every time.
- Know the plan-feature one-liners: Roth IRAs have no lifetime RMDs, governmental 457 plans have no 10 percent early-withdrawal penalty, defined benefit plans favor the older high-earning owner, and SEPs are employer-funded only.
- On death questions, trace the ownership form: JTWROS goes to the survivor outside probate, TIC goes through the estate, and TOD or beneficiary designations override whatever the will says.