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June 14, 2024


Last updated: June 29, 2024

Mastering Investment Recommendations

By: Securities Institute Staff

Mastering Investment Recommendations On The Series 66 Exam
The Uniform Combined State Law Examination

One of the keys to passing the Series 66 exam is to make sure that you have a complete understanding of how investment recommendations will be tested on the Series 66 Exam. This article which was produced from material contained in our Series 66 textbook and will help you master the material so that you pass the Series 66 exam.

Modern Portfolio Theory

As money management developed over the last century, analysts began to shift their focus from the returns available from individual investments to the returns available from an entire portfolio. This approach became known as modern portfolio theory. Modern portfolio theory is based on the concept that investors are risk adverse. Through diversification of investments and asset classes, portfolios can be constructed with higher levels of expected return for each unit of risk assumed. Asset classes are divided into three main categories, stocks, bonds, and, cash and cash equivalents. Portfolio managers, through modern portfolio theory, can construct portfolios based on various allocations over the three main asset classes whose return will be the greatest given each unit of risk. This level of optimal performance is known as the efficient frontier. Any portfolio whose returns are expected to be less than optimal are said to be operating behind the efficient frontier. Optimal portfolio performance will be achieved by constructing a portfolio whose securities prices move independently of one another or whose prices move inversely to one another. Allocating a client’s assets over various asset classes to achieve a given investment objective is known as strategic asset allocation. As the investment results of the different asset classes vary over time, the assets may have to be rebalanced. Asset rebalancing can be divided into two categories: systematic rebalancing and active rebalancing. Systematic rebalancing is designed to keep the original asset allocation model in place. For example, if a client’s portfolio is designed to be 70%/25%/5% in stocks, bonds, and cash respectively, as the percentages shift, the portfolio manager would rebalance the assets to maintain the original percentages. Systematic rebalancing can be done at regular intervals such as quarterly or whenever the asset allocation shifts by a certain percentage, such as by five percent or more. Active rebalancing assumes that a portfolio manager can effectively shift the asset allocation to take advantage of shifts in the performance of the various asset classes. If an investor has the same original portfolio allocation 70%/25%/5% and the portfolio manager thought that the bond market would outperform all other investments, they may use tactical rebalancing to rebalance as follows 40%/55%/5%. Alternatively, Investors may elect to employ a buy and hold strategy and let the allocations go where they may. This buy and hold strategy would reduce transaction costs and tax consequences.

Fundamental Analysis

Fundamental analysts examine the company’s financial statements and financial ratios to ascertain the company’s overall financial performance. The analyst will use the following to determine a value for the company’s stock:

  • The Balance Sheet
  • The Income Statement
  • Financial Ratios
  • Liquidity Ratios
  • Valuation Ratios

The Balance Sheet

The balance sheet will show an investor everything that the corporation owns, or its assets, and everything that the corporation owes, or its liabilities, at the time the balance sheet was prepared. A balance sheet is a “snapshot” of the company’s financial health on the day it was created. The difference between the company’s assets and its liabilities is the corporation’s net worth. The corporation’s net worth is the shareholders’ equity. Remember that the shareholders own the corporation. The basic balance sheet equation is:

Assets – Liabilities = Net Worth

The Balance sheet equation may also be presented as follows:

Assets = Liabilities + Shareholder’s Equity

The two columns on the balance sheet contain the company’s assets on the left and its liabilities and shareholder’s equity on the right. The total dollar amount of both sides must be equal or must “balance”. The entries on a balance sheet look as follows:

Fixed AssetsLong Term Liabilities
Other Assets Equity / Net Worth
 Preferred Stock Par value
 Common Stock Par Value
 Additional Paid in Surplus
 Treasury Stock
 Retained Earnings
  • Money market instruments
  • Marketable securities
  • Accounts receivable net of any delinquent accounts
  • Inventory including work in progress
  • Prepaid expenses

Fixed assets are assets that have a long useful life and are used by the company in the operation of its business. Fixed assets include:

  • Plant and equipment
  • Property and real estate

Other assets are intangible assets that belong to the company. Other assets include:

  • Goodwill
  • Trademarks
  • Patents
  • Contract rights

The liabilities of the corporation are listed in the order in which they become due. Current liabilities are obligations that must be paid within 12 months. Current liabilities include:

  • Wages payable, including salaries and commissions owed to employees
  • Accounts payable to vendors and suppliers
  • Current portion of long term debt, that is, any portion of the company’s long term debt due within 12 months
  • Taxes due within 12 months
  • Short term notes due within 12 months

Long-term liabilities are debts that will become due after 12 months. Long-term liabilities include:

  • Bonds
  • Mortgages
  • Notes

Note: The corporation’s debt, which comes due in five years or more, is known as funded debt.

Stockholders’ equity is the net worth of the company. Stockholders’ equity is broken up into the following categories:

  • Capital stock at par: The aggregate par for both common and preferred stock
  • Additional paid in surplus: Any sum paid over par by investors when the shares were issued by the company
  • Retained earnings: Profits that have been kept by the corporation, sometimes called earned surplus

The term capitalization refers to the sources and makeup of the company’s financial picture. The following are used to determine the company’s capitalization:

  • Long term debt
  • Equity Accounts, including par value of common and preferred and paid in and earned surplus

A company that borrows a large portion of its capital though the issuance of bonds is said to be highly leveraged. Raising money through the sale of common stock is considered to be a more conservative method for a corporation to raise money because it does not require the corporation to pay the money back. When a company borrows funds, it is trying to use that borrowed capital to increase its return on equity.

A fundamental analyst may look at the balance sheet to determine the following financial information:

  • Net Worth
  • Working Capital
  • Current Ratio
  • Quick Assets
  • Acid Test Ratio / Quick Ratio
  • Cash Assets Ratio
  • Debt to Equity Ratio
  • Common Stock Ratio
  • Preferred Stock Ratio
  • Bond Ratio