One of the most heavily tested parts of the Series 7 is analyzing portfolios and securities. This may sound exciting—after all, if you’re trying to work on Wall Street you probably love analyzing stocks and bonds—but remember that the test is about rules and general knowledge, which means the test is more about memorizing standards and rules rather than showing your genius at finding an investment thesis no one else has.
Perhaps aware of this enthusiasm, the Series 7 really tests your ability to match assets with the risk/reward profile of a hypothetical client, emphasizing the importance of recommendations that are appropriate for the investor rather than emphasizing getting the future right. In fact, the Series 7 tests heavily on the ways that financial professionals hedge their uncertainty about the future, either through diversification, actual hedges, or choosing lower risk assets and accepting the commensurate lower return.
To ensure registered representatives know what the right thing to do is, a lot of the Series 7 looks at portfolio analysis. This means learning about the investor’s objectives, the risk they’re comfortable with, and what assets fit what kind of account. The Series 7 is likely to test your knowledge of whether municipal bonds are good for a traditional IRA or 401k account (and you should know they aren’t!).
Objectives are grouped into the following categories, which you should find self-explanatory:
- Capital growth
- Capital preservation
- Diversification
- Current income
- Total return
- Tax benefits
- Liquidity
- Speculation
The test wants to know if you know that an investor concerned about liquidity should be recommended T-Bills before U.S. growth stocks, for instance.
This shouldn’t be too difficult for anyone familiar with capital markets, but you may find the test’s risk aversion is extreme. A good example is if the test asks for the best investment for someone looking to buy a car in 2 years. A T-Bill is the right answer according to the Series 7, even if many would rightly challenge that this isn’t enough to fight inflation.
Their goals are one thing, but their own personal profile is important too. Financial information is necessary before making recommendations: you need to know their net worth, their tax bracket, their income, their expenses, and so on. If you don’t have enough details you can’t make a recommendation—this is a detail the Series 7 will test quite frequently.
Then there’s nonfinancial considerations; investments for younger investors aren’t necessarily good for older ones. Marital status, family size, education, experience, risk tolerance are all considerations in creating an investor’s profile to then make recommendations.
When making recommendations, it’s important to have a strategic asset allocation plan. This simply means adopting a standard or starting point assumed investment strategy and adjusting it to fit the investor.
Let’s clarify with an example. You have a 30-year old client with $500,000 in total assets who has been told to adopt a 60/40 balanced portfolio (equities and bonds respectively). The investor has told you she is particularly aggressive and wants a lot of profits even if the portfolio falls sometimes over the short term. Do you:
A. Tell the investor to stick to a 60/40 mix
B. Tell the investor, due to her age, she should have a 100% bond portfolio
C. Tell the investor to consider increasing their exposure to stocks
D. Tell the investor to start trading options
C is the correct answer here, and this question should be very easy for you. Obviously 60/40 mix is terrible advice for anyone at 30 years old who has decades to allow profits to compound (this is why target-date funds don’t start out with a 60/40 mix). Bonds grow less than stocks so answer B is obviously wrong. The question hasn’t said the investor has any experience with options, so D is out. Thus C is the correct answer—but knowing a 30 year old should have more than 60% of their portfolio in stocks would make C jump out at you, as well.
Will the test question your knowledge of Modern Portfolio Theory? It is likely, but don’t expect too much technical expertise to be required. You’ll need to know what alpha and beta are, but not how to calculate them. You’ll need to know what a CAPM is but not actually create one. And, of course, the test will expect you to know how to look at a balance sheet and income statement, so expect questions on current ratio, working capital, and the quick ratio or acid-test ratio. The test is likely to test your knowledge of how stock issuances and cash dividends influence these calculations as well.