R02 Volatility and diversification: free practice questions

1. Question 1 of 5

   How can volatility be defined?

   Option A: The yield on a bond at redemptionOption B: The proportion of a portfolio held in cashOption C: The average return of an investmentOption D: The dispersion of returns from an investment

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   The answer is D: The dispersion of returns from an investment

   Volatility is the dispersion of returns from a single security or portfolio. Higher volatility generally implies higher risk, but potentially higher returns.

   Why the other options are wrong

   A

   That's the redemption yield.

   B

   That's an asset allocation figure.

   C

   That's the mean, not its dispersion.

2. Question 2 of 5

   A retiree takes a fixed monthly withdrawal from a fund. Why does a sharp fall in markets soon after retirement do particular damage?

   Option A: Fewer units have to be sold at low prices to fund withdrawalsOption B: The fund switches into cash automaticallyOption C: Withdrawals are suspended automatically when markets fallOption D: More units must be sold at low prices to fund each withdrawal

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   The answer is D: More units must be sold at low prices to fund each withdrawal

   This is reverse pound cost averaging: fixed withdrawals sell more units when prices are low, which can erode capital very quickly after a sharp fall.

   Why the other options are wrong

   A

   A fixed sum needs more units when prices are low.

   B

   That isn't how withdrawals work.

   C

   They continue unless the client changes them.

3. Question 3 of 5

   A fund rose to a peak of £150,000, then fell to a low of £120,000 before recovering. What was its maximum drawdown?

   Option A: 25%Option B: 20%Option C: It can't be measured without the starting valueOption D: 80%

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   The answer is B: 20%

   Drawdown = (peak − trough) ÷ peak = £30,000 ÷ £150,000 = 20%.

   Why the other options are wrong

   A

   That divides the fall by the trough value instead of the peak.

   C

   Drawdown is measured from peak to trough, whatever the starting value.

   D

   That's the trough as a percentage of the peak.

4. Question 4 of 5

   Through his employer's share scheme, most of a client's wealth is in his employer's shares. What is the main concern?

   Option A: Employee shares carry no market riskOption B: Employee shares always pay lower dividendsOption C: The company's failure could lead to a very large lossOption D: The shares can't be sold at all while he's employed

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   The answer is C: The company's failure could lead to a very large loss

   A single-company portfolio is more common than might be imagined because of employee share schemes. If the company fails, the loss could be total.

   Why the other options are wrong

   A

   They carry both market and specific risk.

   B

   Dividends don't depend on how shares were acquired.

   D

   Listed shares can usually be sold.

5. Question 5 of 5

   In 2022, longer-dated UK index-linked gilts fell sharply in value. What does this show?

   Option A: Gilts carry high default riskOption B: No investment is entirely free of riskOption C: Index-linked gilts can't be diversifiedOption D: Inflation fell sharply in 2022

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   The answer is B: No investment is entirely free of risk

   Even index-linked gilts, which offer potential inflation protection, produced a large negative return in 2022. No investment is entirely risk free, which is why diversification matters.

   Why the other options are wrong

   A

   The fall wasn't caused by default risk.

   C

   They can be combined with other assets.

   D

   UK inflation rose sharply in 2022.

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