Quiz: Think You Understand Markets? Prove It

Know your stocks from your bonds? Your shorts from your longs? Many investors claim to. Unfortunately, some of those investors don't live up to their expectations. How do you rate? We've selected some questions from the Financial Industry Regulatory Authority's test of investor knowledge. The organization maintains the quiz as part of its mission to promote investor education. See how you do ...

Posted 29 Oct 2009

If you buy a company's stock…

1. You own a part of the company
2. You have lent money to the company
3. You are liable for the company's debts
4. The company will return your original investment to you with interest
5. Don't know/Not sure

Stocks are known as "equities" because each stock share represents a small percentage of ownership in the company, entitling the shareholder to vote in the election of directors and on other matters taken up at shareholder meetings or by proxy.

If you buy a company's bond...

1. You own a part of the company
2. You have lent money to the company
3. You are liable for the company's debts
4. You can vote on shareholder resolutions
5. Don't know/Not sure

Bonds are loans that investors make to a corporation or a government body in exchange from regular interest payments and the return of principal at a future date. Companies issue corporate bonds to raise money for capital expenditures, operations, and acquisitions. But unlike stockholders, bondholders don't receive ownership rights in the corporation.

Which type of bond is the safest?

1. U.S. Treasury bond
2. Municipal bond
3. Corporate bond
4. Don't know/Not sure

"Treasuries" are issued by the federal government. Unlike corporate or municipal bonds, they are backed by the "full faith and credit" of the U.S. government, which guarantees that interest payments will always be made and the bonds redeemed at maturity.

In general, if interest rates go down, then bond prices…

1. Go down
2. Go up
3. Are not affected
4. Don't know/Not sure

The cardinal rule of bonds: When interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. This is because as interest rates go up, newer bonds come to market paying higher interest yields than older bonds already in the hands of investors, making the older bonds worth less.

Which of the following is the best definition for a "junk bond?"

1. A bond that is rated as "below investment-grade" by rating agencies
2. A bond that has declined dramatically in value
3. A bond that has defaulted
4. A bond that is not regulated
5. Don't know/Not sure

"Junk" or "high yield" bonds are issued by companies with poor credit ratings, meaning that compared with better-rated "investment-grade" bonds the risk is greater that these companies will default on their interest payments or even go bankrupt and be unable to redeem their bonds when they mature. To attract investors, "junk" bonds pay higher yields than higher-graded corporate bonds.

A "no-load" mutual fund is one that…

1. Carries no fees
2. Carries no sales charges
3. Does not contain high-risk securities
4. Has no limits on the period of time in which it can be bought and sold
5. Don't know/Not sure

Not all mutual funds charge sales loads. Called no load funds, these funds do not charge a front-end sales charge or a deferred sales charge.

In general, investments that are riskier tend to provide higher returns over time than investments with less risk.

1. True
2. False
3. Don't know/Not sure

The stock and bond markets tend to reward risk-taking over the long term. This is called the risk-reward tradeoff. Over the short term, however, high-risk investments such as small-company stocks can be extremely volatile. The less willing you are to take that risk, the more you may want to emphasize investments that provide a regular return with less volatility, such as short-term bonds.

Which of the following organizations insures you against your losses in the stock market?

1. FDIC (Federal Deposit Insurance Corporation)
2. FINRA (Financial Industry Regulatory Authority)
3. SEC (Securities and Exchange Commission)
4. SIPC (Securities Investor Protection Corporation)
5. None of the above
6. Don't know/Not sure

When you invest in stocks, you accept the risk that your investment may decline as well as rise in value. A primary role of securities regulators such as FINRA and the SEC is to ensure that securities laws and regulations are followed and to punish violators. The FDIC generally insures checking, savings,and other deposit accounts when an FDIC-regulated bank fails. The mission of the Securities Investor Protection Corporation (SIPC) is to return funds and securities to investors if the brokerage firm holding these assets becomes insolvent.

If a company files for bankruptcy, which of the following securities is most at risk of becoming virtually worthless?

1. The company's preferred stock
2. The company's common stock
3. The company's bonds
4. Don't know/Not sure

Among those with claims to a bankrupt company's assets, shareholders of common stock have the last claim on any assets, falling in line behind secured creditors, bondholders, and owners of preferred shares.

Which of the following best explains why many municipal bonds pay lower yields than other government bonds?

1. Municipal bonds are lower risk
2. There is a greater demand for municipal bonds
3. Municipal bonds can be tax-free
4. Don't know/Not sure

Because dividend payments from municipal bonds are usually exempt from federal income tax, even with lower yields than other government bonds their after-tax rates of return are attractive to investors in higher tax brackets.

You invest $500 to buy $1,000 worth of stock on margin.  The value of the stock drops by 50%.  You sell it.  Approximately how much of your original $500 investment are you left with in the end?

1. $500
2. $250
3. $0
4. Don't know/Not sure

When you buy stock on margin, you risk losing your entire investment - or much more. In this example an investor used $500 to buy $1,000 worth of stock, borrowing the additional $500 from a brokerage firm to make the purchase. When the stock was sold after dropping 50% in value, its remaining worth was only $500 - the same amount the investor still owed to the brokerage firm for the margin loan.

Which is the best definition of "selling short"?

1. Selling shares of a stock shortly after buying it
2. Selling shares of a stock before it has reached its peak
3. Selling shares of a stock at a loss
4. Selling borrowed shares of a stock
5. Don't know/Not sure

Short selling involves borrowing stock from a broker through a margin account and selling it, with the understanding that it must later be bought back and returned to the broker. If the stock declines in value, as the short seller hopes, the investor will profit since the value of the stock borrowed and sold would be higher than the stock subsequently purchased and returned to the broker.

Hedge funds are always subject to the same rules and regulations as mutual funds.

1. True
2. False
3. Don't know/Not sure

Hedge funds are basically private investment pools. Because they are usually only open to limited numbers of wealthy, financially sophisticated investors and do not advertise or publicly offer their securities, private hedge funds are usually not required to register with the SEC. As a result, unregistered private hedge funds do not provide many of the investor protections that apply to registered investment products such as mutual funds.

A Section 529 Plan is a tax-advantaged way to save for:

1. College
2. Retirement
3. Long-term health care
4. Don't know/Not sure

Named after the section of the federal tax code that governs them, Section 529 plans are tax-advantaged programs that help families save for college.

Your score:

• Perfect We should give you your own show.
• You are a pro.
• Semi-pro.
• Amateur (You might want to brush up at Fast Money's Trade School.)
• Uh-oh ... (You may want to visit the CNBC Investor Center and start reading... lots.)

*Questions provided by the Financial Industry Regulatory Authority.