Study guide
Section III is 30 percent of the exam, about 30 scored questions, and it is where product knowledge meets real clients. Expect scenario questions on client profiling, portfolio theory and strategy, taxation, retirement plans and other tax-advantaged accounts, account ownership and estate techniques, trading mechanics, and performance measurement. Suitability reasoning, matching the recommendation to the specific facts given, is the recurring skill.
Knowing the Client: Types and Profiles
Recommendations begin with who the client is. Individuals and sole proprietorships are taxed at personal rates, while business entities differ sharply: general partners bear unlimited personal liability, limited partners are liable only up to their investment, LLCs give members liability protection with pass-through taxation, S corporations pass income through to a limited number of shareholders, and C corporations pay entity-level tax with a second tax on dividends to shareholders. For trusts and estates, the adviser must read the trust document, identify the trustee's authority, and remember the trustee's fiduciary duty to invest prudently for beneficiaries under prudent investor standards, judging the portfolio as a whole. Foundations and charities typically invest for long horizons under board-approved investment policy statements. Building the client profile means gathering financial data, including cash flow, a personal balance sheet, existing investments, tax situation, and expected Social Security and pension income, alongside goals and time horizon. Distinguish risk tolerance, the client's psychological willingness to accept losses, from risk capacity, the financial ability to absorb them; a recommendation must respect the more limiting of the two. Nonfinancial considerations matter as well: values-based preferences such as environmental, social, governance, or religious screens, investment experience, life stage, and major life events. Behavioral finance describes predictable irrationality, such as loss aversion (losses hurt more than equivalent gains please) and overconfidence. Time horizon drives allocation: Priya, age 30 and saving for retirement, can hold mostly equities, while a couple needing a house down payment in two years belongs in cash equivalents and short-term debt regardless of their stated appetite for risk.
Capital Market Theory and Portfolio Strategy
Three frameworks anchor the theory questions. The Capital Asset Pricing Model (CAPM) says an asset's expected return equals the risk-free rate plus beta times the market risk premium: with a 3 percent T-bill rate, a 9 percent expected market return, and a beta of 1.5, expected return is 3 + 1.5 times (9 minus 3), or 12 percent. Modern Portfolio Theory (MPT) evaluates each asset by its effect on the whole portfolio's risk and return, seeking efficient portfolios that maximize return for a given risk level; combining assets with low correlation moves a portfolio toward that efficient frontier. The Efficient Market Hypothesis (EMH) holds that prices already reflect available information. Its weak form says past prices are fully reflected, making technical analysis futile; the semi-strong form adds all public information, defeating fundamental analysis; the strong form says even inside information is priced in. Strategy questions turn on vocabulary. Strategic asset allocation sets long-term target percentages based on the client's objectives and rebalances back to targets periodically; rebalancing forces selling what has risen and buying what has lagged. Tactical allocation makes short-term shifts to exploit market conditions, an active market-timing approach. Active management tries to beat a benchmark; passive management buys and holds an index. Styles include growth, value, income, and capital appreciation. Techniques include diversification, sector rotation (shifting among industries with the business cycle), dollar-cost averaging (investing a fixed dollar amount regularly, which buys more shares when prices are low and yields an average cost per share below the average price), hedging with options, leveraging, volatility management, and inverse strategies.
Tax Considerations for Individuals, Entities, and Estates
Securities sold after being held more than one year generate long-term capital gains taxed at preferential rates of 0, 15, or 20 percent depending on income, plus a 3.8 percent net investment income tax for high earners; holdings of one year or less produce short-term gains taxed as ordinary income at the taxpayer's marginal bracket, the rate applied to the next dollar earned. Capital losses offset gains, and up to $3,000 of excess loss offsets ordinary income annually, with the remainder carried forward. Qualified dividends, generally those on stocks held past a minimum period, also enjoy the long-term capital gains rates. Cost basis rules are heavily tested: inherited property takes a stepped-up basis equal to fair market value at the owner's death and is automatically treated as long-term, while gifted property carries over the donor's original basis for gains. The alternative minimum tax is a parallel calculation that adds back certain preference items, including interest on private activity municipal bonds. Entity taxation contrasts C corporations, taxed at the entity level with dividends taxed again to shareholders, against pass-through structures such as S corporations, LLCs, partnerships, REITs, and master limited partnerships, whose income flows to owners' returns. For wealth transfer in 2026, each person may gift $19,000 per recipient per year under the annual exclusion without filing a gift tax return, and the unified lifetime estate and gift exemption is $15 million per person, with portability allowing a surviving spouse to use a deceased spouse's unused exemption. Transfers between spouses are unlimited under the marital deduction. Distributions from pretax retirement plans are ordinary income and can raise Medicare premiums through income-related monthly adjustment amounts (IRMAA).
Retirement Plans and Tax-Advantaged Accounts
Traditional IRAs accept contributions that may be tax-deductible, grow tax-deferred, and are taxed as ordinary income on withdrawal, generally with a 10 percent penalty before age 59 and a half and required minimum distributions (RMDs) beginning at age 73. Roth IRAs take after-tax contributions, grow tax-free, pay no tax on qualified withdrawals, and impose no lifetime RMDs on the owner; eligibility phases out at higher incomes. For 2026 the IRA contribution limit is $7,500 plus a $1,100 catch-up at age 50. Employer plans divide into defined benefit plans, which promise a formula-based pension and put investment risk on the employer, and defined contribution plans such as 401(k), 403(b) for nonprofits and schools, and 457 for government workers, where the employee bears investment risk; the 2026 employee deferral limit for a 401(k) is $24,500 plus an $8,000 catch-up at 50. Small employers may use SEP or SIMPLE IRAs, and a self-employed person with no employees can use a solo 401(k). Nonqualified deferred compensation plans may discriminate in favor of executives but are unfunded promises exposed to the employer's creditors. ERISA governs private qualified plans, imposing fiduciary duties on plan sponsors; a qualified default investment alternative (QDIA), such as a target-date fund, protects fiduciaries who default non-electing participants into it, and offering diversified choices is part of the duty. Education accounts include 529 plans, funded with after-tax dollars, growing tax-free for qualified education costs, allowing five years of annual exclusions ($95,000) up front, and covering K-12 tuition up to $20,000 per year beginning in 2026, and Coverdell accounts capped at $2,000 per year. UTMA/UGMA custodial accounts are irrevocable gifts taxed to the minor, and health savings accounts pair with high-deductible health plans to offer deductible contributions, tax-free growth, and tax-free medical withdrawals.
Account Ownership, Trading, and Measuring Performance
Ownership form controls what happens at death. Joint tenants with rights of survivorship (JTWROS) passes a decedent's interest automatically to the surviving owner, bypassing probate; tenants in common (TIC) lets each owner's share pass to that owner's estate; tenancy by the entirety is a JTWROS variant reserved for spouses; and community property with rights of survivorship applies in certain states. Transfer-on-death and pay-on-death registrations pass assets directly to named beneficiaries, and a per stirpes designation sends a deceased beneficiary's share down to that person's descendants. Revocable living trusts avoid probate but stay in the grantor's taxable estate; irrevocable trusts can remove assets from it. A qualified domestic relations order (QDRO) divides retirement plan assets in divorce without the early withdrawal penalty, and donor-advised funds give an immediate charitable deduction with grants recommended later. Trading questions test mechanics: a market order executes immediately at the best available price, a limit order sets a maximum purchase or minimum sale price but may never execute, and a stop order becomes a market order once the stop price trades. Short sales, selling borrowed shares hoping to repurchase lower, require margin accounts, where investors borrow against securities under Regulation T's 50 percent initial requirement. Broker-dealers acting as agents charge commissions; acting as principals from inventory, they charge markups or markdowns. Introducing firms take orders while clearing firms custody assets, and firms owe clients best execution and must disclose payment for order flow. For performance, time-weighted return measures the manager by removing the effect of deposits and withdrawals, while dollar-weighted return, an IRR, measures the investor's actual experience including cash-flow timing. Also know annualized, total, holding-period, after-tax, and inflation-adjusted (real) returns, current yield as annual income divided by current price, and the need to compare results against an appropriate benchmark.
Key terms
- Risk tolerance
- — A client's psychological willingness to accept investment losses, distinct from financial capacity to absorb them.
- 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.
- Strategic asset allocation
- — Setting long-term portfolio target weights based on client objectives and rebalancing back to them.
- Dollar-cost averaging
- — Investing a fixed dollar amount at regular intervals, producing an average cost per share below the average price.
- Stepped-up basis
- — The rule resetting inherited property's cost basis to fair market value at the owner's death.
- Marginal tax bracket
- — The tax rate applied to a taxpayer's next dollar of income.
- Required minimum distribution (RMD)
- — The mandatory annual withdrawal from pretax retirement accounts beginning at age 73.
- QDIA
- — A qualified default investment alternative, such as a target-date fund, into which non-electing plan participants may be defaulted.
- JTWROS
- — Joint ownership under which a deceased owner's interest passes automatically to the survivor, avoiding probate.
- Time-weighted return
- — A return measure that removes the effect of client deposits and withdrawals, used to judge the manager.
- Qualified dividend
- — A dividend meeting holding-period rules and taxed at preferential long-term capital gains rates.
Exam tips
- Inherited versus gifted securities is a classic trap: inherited assets get a stepped-up basis and automatic long-term treatment; gifted assets carry over the donor's basis for gains.
- Time-weighted return judges the portfolio manager; dollar-weighted (IRR) return reflects the investor's own deposits and withdrawals. Questions signal the answer by asking whose performance is being measured.
- When a question pits stated risk tolerance against a short time horizon or thin finances, the limiting factor wins: an aggressive 68-year-old who needs the money in two years still gets a conservative recommendation.
- Roth IRAs have no lifetime RMDs for the owner; traditional IRAs and pretax employer plans require them at 73. An answer claiming Roth IRAs force lifetime distributions is wrong.
- For joint accounts, match the registration to the estate goal: JTWROS bypasses probate to the co-owner, while TIC sends the decedent's share to the estate, so unmarried partners or business associates wanting separate heirs need TIC.