Series 65 Exam Questions & Answers (SIA Instructor Verified)

As with any investment, equity indexed annuities are suitable for some investors. EIAs are insurance products that appeal primarily to investors interested in safety of their invested principal. That is because a large annual gain is not possible from an indexed annuity, not only due to the participation rate, but also because these contracts typically have a cap, a maximum amount that the contract can increase in value in any one year, regardless of the performance of the index on which it is based. 

Let’s look at a hypothetical indexed annuity, with a participation rate of 70% and a cap of 6%. What happens if the S&P rises 30%? The 70% participation rate of this 30% is 21%; however, due to the 6% cap, the contract’s value would increase by only 6% in that year. 

To put this feature in perspective, let’s look at historical returns for the S&P 500 over 10 years, going back a few years now:

Going back to 2014 investors in an S&P 500 index fund had two years that were negative—2018 and 2022. Unlike in an ETF or other indexed fund, in an indexed annuity, the contract values would have, instead, increased by the minimum guaranteed rate both years. 

On the other hand, owners of an indexed annuity would have missed out on the difference between the indexed annuity’s capped return and 11.9% in 2016, 21.8% in 2017, 28.9% in 2019, 16.3% in 20120, 19.4% in 2017, 28.9% in 2019, 16.3% in 2020, 26.9% in both 2021 and 2023, and 12.5% in 2024. That is a lot of growth to miss out on!

As we can see, the equity indexed annuity is suitable for an investor looking for a guaranteed minimum return. Investors looking for growth/purchasing power protection are better served in an index fund without any bells or whistles, whether an open-end fund or an ETF tied only to a particular index.

Open-end and closed-end funds have more similarities than differences. In either case, a registered investment adviser manages a portfolio of securities, with ownership of that portfolio then subdivided into the shares owned by investors. Each trading day, the NAV of the fund rises or falls based on market prices of portfolio securities and any dividend or interest income generated by the stocks and bonds in the portfolio. The registered investment adviser has a contract with the Board of Directors for the fund and is paid a percent of portfolio assets under management plus bonuses for hitting or exceeding certain benchmarks.

The differences include, first, how the shares of the fund are bought and sold by investors. Open-end fund shares are sold from the fund to investors and repurchased from investors who want to redeem/sell them. Closed-end fund shares, on the other hand, trade on the secondary market. Therefore, a closed-end fund such as BXMX is bought and sold just like shares of MSFT or MCD are—among investors. For that reason, the market price of a closed-end fund may be higher or lower than the NAV. Open-end fund shares do not have market prices. They are redeemed for the next-calculated NAV and purchased based on the next-calculated NAV—sometimes with a sales charge added.

The other difference is that closed-end funds typically use leverage. That means some investors are preferred stockholders and some may hold bonds. Both types of investors have higher claims on the income generated by the portfolio than do owners of the common shares. This is what makes closed-end funds as a class more aggressive than open-end funds, even if the portfolios hold similar securities.

FINRA's guidance on this point is clear. As you may know, Form U4 asks if the applicant has ever been charged with any felony, and whether convicted of any felony. Some exam candidates confuse the “ever” with a 10-year period looking back from the date of application. They mistakenly think if a felony conviction occurred 12 years ago, the applicant can answer “No” to these questions/items. Turns out, any felony charge and any felony conviction must be disclosed, no matter how long ago it took place. Failing to disclose the information is a game-over for any state regulator, the SEC, or FINRA, too.

What about a pardon? An individual pardoned was, first, convicted of the crime. And, he/she was, also, formally charged with the crime. So, as nice as it must be to get out of prison sooner than expected, the pardon does not change either answer on Form U4. Yes, the pardoned individual was both charged and convicted of a felony offense.

Exam candidates know that closed-end fund shares trade among investors on the secondary market. Does that mean for closed-end funds the imbalance of buying and selling interest does determine the NAV?

No. The Net Asset Value for either an open-end or closed-end fund is the difference between the assets of the securities portfolio, minus any liabilities, divided by the outstanding shares. Open-end funds don’t borrow a lot of money, so their liabilities are minimal. At the end of each market session, the value of all stocks and bonds in the portfolio are revalued. Those, plus all the cash the portfolio has generated, are the assets. The liabilities are the amounts borrowed short-term, perhaps to pay investors who redeem shares. Take the assets, minus the liabilities, and divide those net assets by the number of outstanding shares.

That is the new NAV for the fund.

Only now are shares redeemed at that price or sold to investors at a price based on this new NAV. The transfer agent is merely turning cash into shares, or shares into cash, based on this new Net Asset Value per share. Investors’ shares are not being traded among investors.

The NAV is calculated the same way, and only once a day, for a closed-end fund. The shares trade throughout the day, at a market price that could be above or below the NAV.

Many exam candidates struggle with the difference between stop and limit orders. However, they are quite different. When an investor enters a limit order to buy or sell, the investor is ready to buy or sell the security. He simply wants to buy or sell it at a specific price—or not at all. And, logically, the price he wants to buy or sell the security at is better than the current bid or ask for the security. If ABC can be purchased for $50.12 now, a buy-limit order would be placed at a better price than that—a lower price. Maybe the investor places an order to buy 300 ABC @$50, limit.

That is a buy-limit at $50 order. Only if the Ask price drops to $50 or lower—and there are 300 shares available at the time—will that purchase order be filled.

Other investors may hold shares of ABC. Those interested in selling, say, 400 shares may also choose to name a price for execution. If the Bid is currently $50.10, maybe one investor decides she is willing to sell 400 shares of ABC if she can get at least $50.25 per share. If so, she enters an order to sell 400 ABC @50.25, limit. Only if the Bid rises to at least $50.25 will that order be executed.

Notice in both cases the price for execution is more important than getting the order filled. If an exam question asks which type of order to use when the investor wants to make sure the order is filled, the answer is a “market order.” Market orders are filled at either the best available Bid (sell orders) or Ask (buy orders) prices.

Stop orders come from a much different perspective than limit orders. Limit orders are placed by investors who want a particular price—or better—and are willing to forego the transaction altogether if that price is unobtainable. Stop orders are used to protect a stock position, especially if a small “paper gain” has already occurred. For example, maybe an exam question says an investor purchased $8,000 of XYZ common stock, which now trades for $10,000…which type of order can protect this “paper gain”?

We are not saying he is ready to sell XYZ common stock.  But he has a 25% gain on his hands. Maybe he owns 100 shares of XYZ, now trading at $100 per share. If so, he could place a sell-stop order with an activation price below the current market price. Maybe he places an order to sell 100  XYZ @99.10, stop.

Best case, the stock stays at $100 or rises a few dollars per share. If so, he can cancel that stop order and place a new one, at a higher activation price. But, as long as that sell-stop order is there, just below the current market price, the investor can focus on other things, knowing the next time he checks his account, he will either still hold 100 shares of XYZ—at a favorable market price—or, he will have about $9,910 in cash, as a result of that sell-stop order being triggered and filled.

With a sell-limit order, the investor would simply sell XYZ for a little more than the current market/ask price. With a sell-stop order, he can ride out the position, knowing the worst case is an automatic sale, which often represents a profit. In our example, he bought the stock for $80 a share; therefore, if it is triggered and sold for about $99.10, that represents a pretty good outcome. Even better would be for XYZ common stock to rise to $110, then $120, then…who knows?

The state securities Administrator regulates all investment adviser representatives in the state and all state-registered investment advisory firms. If an IAR or RIA is found to be harming investors and violating securities regulations, the individual or firm receives a notice from the Administrator announcing the alleged violations, explaining the rules/laws allegedly violated, and announcing the upcoming hearing—or how the respondent may request a hearing. After a disciplinary hearing is held, an order to suspend or revoke the license of an IAR or RIA may be issued.

On the other hand, if an individual or business outside the advisory business is, for example, issuing promissory notes to investors in the state and failing to honor the terms of the securities, the Administrator has no license to threaten to suspend or revoke. In these cases, a cease and desist order is typically issued. 

Only a judge/court of law has the authority to issue an injunction. If an injunction is issued against any person (individual or firm), the Administrator can use that to deny, suspend, or revoke an application or registration. So, the individual issuing bogus promissory notes is still not facing dire consequences, although his ability to work as an agent, IAR, etc. in the future is doubtful. And, if a court of law were to issue a restraining order/injunction against an individual selling promissory notes in a way that violates the law and the individual disregards the order, criminal penalties are a possible outcome.

There are two types of investment risk. Systematic risks affect securities system-wide, whereas unsystematic risks affect only certain market sectors or companies at any given time. Diversification spreads unsystematic risks among many issuers and industry groups. It has no effect on the first type, systematic risk.

For example, market risk is a type of systematic risk that affects securities across the board. Market risk is the risk that an investment will lose value due to an overall market decline. No one can predict the next war, pandemic, or banking crisis, but when events like that take place, they can have a devastating effect on the overall market for stocks and bonds. 

Whether they panic because of war, weather, or whatever, when investors panic, securities prices drop. So, even if an investor holds shares in several solid companies, when securities holders all try to sell at the same time, the market prices of securities across the board drop. 

Unfortunately, diversification does not help in this case. If the overall market is going down, it does not matter how many different stocks or bonds we own. They are all going down. That is why we would have to bet against the overall market to protect against market risk. The S&P 500 index is generally used to represent the overall stock market. Therefore, investors use options, futures, and ETFs based on such indexes to bet the overall market will drop. 

Beta measures market risk. A beta of 1.3 indicates the stock is more volatile than the S&P 500—1.3 times as much, and the S&P 500 is already volatile. A beta of .8 indicates the stock is less volatile than the S&P 500—only 80% as volatile. The higher the beta of a stock, the greater the market risk faced by an investor in that security. Investors following modern portfolio theory and its related tenets believe this is the only type of risk an investor should expect to be compensated for taking. 

Why? Because unsystematic risks can be diversified and thereby reduced. This type of systematic risk is “non-diversifiable,” and so the more of it one faces, the higher the potential return.

Most investors purchase securities, hoping they increase in value. Short sellers, on the other hand, bet that a security’s price is about to drop and profit if they are correct.

It works sort of like this. You go to your friend’s house and see that she has a new mountain bike that she paid too much money for. Mind if I borrow your mountain bike, you ask, to which your friend agrees. On the way home you run into another friend, who admires the bike so much that she offers you two thousand dollars for it.

Sold! You take the $2,000 and put it in your pocket.

Wait a minute, that wasn’t even your mountain bike! No problem. A few days later you go to the bike store to replace the borrowed bike, and—as predicted—the price has fallen to just $1,000. Perfect! 

You sold the bike for $2,000 and you can get out of your position by paying only $1,000, keeping the $1,000 difference as your profit. Buy the bike for $1,000, wheel it over to your friend to cover the one you borrowed, and everyone is happy. 

Notice that you made money when the price went down. Therefore, you were "bearish" on the price of mountain bikes.

Short sellers do not sell bikes or software companies short, but they can sell the stock of companies who make bikes or software short. If investors think Apple or Alpha common stock is overpriced and headed for a drop, they can borrow the shares from their broker-dealers and sell them at what they feel is the top. 

However, many people tried that after Facebook went public at $38. When it got to $50, many were convinced the stock would only go down from there, so they sold it short at $50. Expecting to buy it back or “cover their short positions” for less than $50, these traders must have been embarrassed to see the stock soon climb to nearly $200 per-share.

Selling for $50 and buying for $200 is not a good trade. It is no different from buying for $200 and then selling for $50. It is just more dangerous. When we buy, we have already lost all we could ever lose. But when we sell stock short, there is no limit to how much we will have to spend to get out of the position.

Short sellers profit when the price of the stock goes down, but they have limited upside and unlimited risk. If an investor sells a stock short for $5,000, $5,000 is the maximum gain, and only if the stock went to zero. On the other hand, the potential loss is unlimited, since no one can say for sure how high the stock could rise, representing the purchase price.

Stock is not the only thing that can be sold short. Treasury securities are frequently sold short, as are corporate bonds, ETFs (exchange-traded funds), and closed-end funds. Writers of options are “short the option” and complete the trade when they buy it back to close.

In cash accounts, customers pay for securities purchases in full, no later than settlement. On the other hand, margin accounts allow customers to purchase securities on credit. These customers then pledge the securities they are purchasing on credit as collateral to the lender, the broker-dealer. If the market value of the securities drops, the broker-dealer can sell the securities to recover the money it lent the customer. 

The fact that the broker-dealer has collateral backing the loan to the customer allows them to charge a lower interest rate than that typically paid on a credit card. Moreover, this interest is tax-deductible, helping offset portfolio income for that year.

The use of borrowed money to earn potentially outsized returns is a form of leverage. Like bonds, private equity, and closed-end funds, margin accounts are associated with use of leverage. Investing on margin is a high-risk strategy that involves buying securities on credit in hopes of making more on the securities positions than the broker-dealer charges in interest on the margin loans. By using leverage in a margin account, investors double their potential gains, but also double their potential losses.

The term “equity” is often used in relation to real estate. Let’s say a homeowner buys a property for $200,000 and borrows $100,000 to do so. The mortgage account starts out looking like this:

Equity is ownership and equals the difference between what someone owns (assets) and owes (liabilities). As with a margin account, the initial equity is the investor’s down payment. Assume that this home’s value then increases 5% annually for three years running, and the homeowner also pays down some principal. At this point, the account looks like this:

The equity is just a number, but the customer can decide to borrow against that amount, either all at once or going forward as needed.

In a margin account, investors buy stocks and bonds on credit. If their market value rises, they win. What if their market value drops? Then, they have a problem. 

Buying securities on margin increases both potential gains and losses to the investor.

Growth stocks trade at high P/E and price-to-book ratios. When a stock is trading at 35 or 50 times the earnings, every earnings announcement can move the stock's price dramatically. A growth investor must have a long time horizon and the ability to withstand large fluctuations in the market price of the investments. A growth investor is not seeking dividend income.

Value investors buy stocks trading at low price-to-earnings and price-to-book ratios. A value investor often purchases stocks in out-of-favor corporations trading for less than they should be. For example, when the company’s CEO is testifying before Congress over badly handled recalls, many traders dump shares of the stock, while value investors might buy shares at currently depressed prices. 

Value stocks that pay dividends typically have high dividend yields. The board of directors does not usually cut or suspend the dividend paid to common stockholders, so the decreasing market price raises the yield. 

A value stock could trade at a low multiple for many reasons. It could be the company has recently stumbled, or has lost the media buzz it once had, or that the industry sector is currently out of favor or in a period of contraction. In general, large, established companies trade at lower P/E ratios. Younger companies are associated with stock trading at high P/E ratios, as the future is a blank slate supported by a very short history of financial results and much conjecture.

The goal for both growth and value investors is the same. They both want the market price of their stock to rise. The difference is in the price points at which they make their purchases. Growth investors buy expensive stocks expected to rise even more in the future, while value investors buy stocks they are convinced are worth more than the market realizes. 

If the two groups invested in real estate, growth investors would buy new properties in the hot part of town, while value investors would favor fixer-uppers that can be rented for a few years and then sold at a profit.