STUDY QUESTIONS AND ANSWERS ON INVESTMENT AND PORTFOLIO MANAGEMENT

By Caliph Blog August 22, 2025

Study Questions and Answers on Investment and Portfolio Management

Investment and portfolio management is a fundamental area in finance that deals with how individuals and institutions allocate funds across assets to achieve specific objectives. Students and professionals alike often seek practical questions and answers to deepen their understanding of key concepts in this field.

This guide presents a comprehensive collection of study questions (both theoretical and application-based) with detailed answers, covering the essentials of investment and portfolio management.

Part 1: Fundamental Concepts

Q1. What is an investment?

Answer:
An investment refers to the commitment of money or capital into an asset, security, or project with the expectation of earning a return in the future. Investments may be made in stocks, bonds, real estate, mutual funds, or business ventures. The central goal is to generate income or capital appreciation over time.

Q2. What are the main objectives of investment?

Answer:
The objectives of investment include:

Safety of Principal – preserving the original capital invested.
Regular Income – earning dividends, interest, or rent.
Capital Appreciation – increasing the value of assets over time.
Liquidity – ensuring easy conversion of assets into cash.
Hedging Against Inflation – protecting purchasing power by investing in assets that grow faster than inflation.

Q3. Define portfolio management.

Answer:
Portfolio management is the art and science of selecting and overseeing a group of investments that meet an investor’s long-term financial objectives and risk tolerance. It involves asset allocation, diversification, monitoring, and rebalancing to optimize returns while managing risk.

Q4. What is the difference between active and passive portfolio management?

Answer:

Active Portfolio Management: Involves frequent buying and selling of securities by portfolio managers who attempt to outperform the market using research, forecasts, and timing strategies.
Passive Portfolio Management: Involves replicating a market index (e.g., S&P 500) with minimal trading, aiming to match rather than beat market returns.

Q5. Explain the concept of diversification.

Answer:
Diversification is the strategy of spreading investments across different asset classes, industries, or geographical regions to reduce risk. By holding a variety of assets, poor performance in one investment can be offset by better performance in others, lowering overall portfolio risk.

Part 2: Risk and Return

Q6. Define risk in investment.

Answer:
Risk refers to the possibility that the actual return on an investment will differ from the expected return. It includes both the chance of losing some or all of the invested capital and the variability of returns.

Q7. What are the types of investment risk?

Answer:

Market Risk – risk of losses due to market fluctuations.
Credit Risk – risk that a borrower defaults on a loan or bond.
Liquidity Risk – difficulty in selling an asset quickly at a fair price.
Inflation Risk – erosion of returns due to rising prices.
Interest Rate Risk – effect of changing interest rates on bond values.
Currency Risk – risk due to exchange rate fluctuations.

Q8. What is the risk-return trade-off?

Answer:
The risk-return trade-off states that higher potential returns are generally associated with higher risks. For example, stocks usually offer higher returns than bonds but are more volatile. Investors must balance their desire for returns with their tolerance for risk.

Q9. How is expected return calculated?

Answer:
The expected return is the weighted average of possible returns, with probabilities assigned to each outcome:

E(R) = \sum [P_i \times R_i]

Where:

$P_i$ = probability of outcome i
$R_i$ = return in outcome i

Example: If there is a 50% chance of earning 10% and a 50% chance of earning 6%, then:

E(R) = (0.5 \times 10\%) + (0.5 \times 6\%) = 8\%

Q10. What is standard deviation in investment?

Answer:
Standard deviation measures the variability of investment returns around the mean (average) return. A higher standard deviation indicates higher risk (greater volatility). It is one of the most common measures of risk in portfolio management.

Part 3: Portfolio Theories

Q11. Explain Modern Portfolio Theory (MPT).

Answer:
Proposed by Harry Markowitz, MPT states that investors can construct portfolios to maximize expected return for a given level of risk through diversification. It introduces the concept of the efficient frontier, which represents the set of optimal portfolios offering the best risk-return combinations.

Q12. What is the Capital Asset Pricing Model (CAPM)?

Answer:
CAPM explains the relationship between expected return and systematic risk. The formula is:

E(R_i) = R_f + \beta_i (R_m - R_f)

Where:

$E(R_i)$ = expected return on asset i
$R_f$ = risk-free rate
$R_m$ = expected return on the market
$\beta_i$ = asset’s beta (systematic risk measure)

CAPM helps in estimating the required rate of return for an investment, considering its risk relative to the market.

Q13. What is Beta in portfolio management?

Answer:
Beta measures an asset’s sensitivity to market movements.

Beta = 1 → moves with the market
Beta > 1 → more volatile than the market
Beta < 1 → less volatile than the market
Negative Beta → moves inversely with the market

Q14. Differentiate between systematic and unsystematic risk.

Answer:

Systematic Risk: Market-wide risk that cannot be eliminated by diversification (e.g., inflation, recessions).
Unsystematic Risk: Firm-specific risk (e.g., management failure, product recall) that can be reduced through diversification.

Q15. What is the Efficient Market Hypothesis (EMH)?

Answer:
EMH suggests that asset prices fully reflect all available information. Hence, consistently outperforming the market through stock selection or timing is nearly impossible. EMH exists in three forms:

Weak Form: Prices reflect past trading data.
Semi-Strong Form: Prices reflect all publicly available information.
Strong Form: Prices reflect all information (public and private).

Part 4: Practical Applications

Q16. An investor has two securities: Stock A (expected return 12%, standard deviation 10%) and Stock B (expected return 8%, standard deviation 6%). If the correlation between them is 0.2, explain whether combining them is beneficial.

Answer:
Since correlation (0.2) is low and positive, diversification reduces portfolio risk compared to holding one stock alone. The portfolio will benefit from risk reduction due to imperfect correlation, though the benefit would be greater if correlation were closer to 0 or negative.

Q17. What is portfolio rebalancing and why is it important?

Answer:
Portfolio rebalancing is the process of realigning the weight of assets in a portfolio to maintain the desired risk-return profile. Over time, some assets may grow faster than others, shifting the portfolio away from the target allocation. Rebalancing ensures that the portfolio remains consistent with the investor’s objectives.

Q18. What is the difference between value investing and growth investing?

Answer:

Value Investing: Focuses on buying undervalued stocks with strong fundamentals but temporarily low prices.
Growth Investing: Focuses on companies expected to grow faster than the market, often reinvesting earnings rather than paying dividends.

Q19. Explain dollar-cost averaging (DCA).

Answer:
DCA is an investment strategy where an investor invests a fixed amount of money at regular intervals, regardless of market conditions. This approach reduces the risk of timing the market, as more shares are purchased when prices are low and fewer when prices are high.

Q20. What role do mutual funds and ETFs play in portfolio management?

Answer:

Mutual Funds: Professionally managed funds pooling investors’ money into diversified securities.
ETFs (Exchange-Traded Funds): Similar to mutual funds but trade like stocks on exchanges.
Both provide diversification, liquidity, and access to a variety of asset classes for individual investors.

Part 5: Advanced Topics

Q21. Define Sharpe Ratio and explain its significance.

Answer:
The Sharpe Ratio measures risk-adjusted return:

\text{Sharpe Ratio} = \frac{R_p - R_f}{\sigma_p}

Where:

$R_p$ = portfolio return
$R_f$ = risk-free rate
$\sigma_p$ = standard deviation of portfolio returns

A higher Sharpe Ratio indicates better risk-adjusted performance.

Q22. What is hedging in portfolio management?

Answer:
Hedging involves using financial instruments (like derivatives—options, futures, or swaps) to protect a portfolio from adverse price movements. For example, buying a put option on a stock provides insurance against price declines.

Q23. Explain asset allocation strategies.

Answer:

Strategic Asset Allocation – fixed percentage allocation (e.g., 60% stocks, 40% bonds).
Tactical Asset Allocation – short-term adjustments based on market conditions.
Dynamic Asset Allocation – continuous rebalancing as markets or personal goals change.

Q24. What is behavioral finance, and how does it affect portfolio management?

Answer:
Behavioral finance studies how psychological biases (e.g., overconfidence, loss aversion, herd behavior) influence investment decisions. Recognizing these biases helps investors avoid irrational decisions that can harm portfolio performance.

Q25. What are alternative investments, and why are they important in portfolio management?

Answer:
Alternative investments include assets outside traditional stocks and bonds, such as real estate, commodities, hedge funds, and private equity. They often have low correlation with traditional markets, providing diversification and potential for higher returns.

Conclusion

Investment and portfolio management is a blend of science and art. It requires understanding fundamental principles, assessing risk and return, applying theoretical models, and making practical decisions in real-world scenarios. By studying and practicing with questions like those above, students and investors alike can strengthen their knowledge, sharpen analytical skills, and make informed financial decisions.

Whether you are preparing for exams or managing your personal wealth, mastering these concepts will give you a strong foundation for success in the world of investments.

Understanding IRR, ARR, and NPV in Investment Appraisal

When businesses or investors consider new projects, they need to evaluate whether those projects will be profitable. To do this, several financial appraisal methods are used. Among the most common are:

Net Present Value (NPV)
Internal Rate of Return (IRR)
Accounting Rate of Return (ARR)

1. Net Present Value (NPV)

Definition

NPV is the difference between the present value of cash inflows and the present value of cash outflows over a project’s lifetime. It tells you how much value an investment is expected to add.

Formula

NPV = \sum \frac{C_t}{(1 + r)^t} - C_0

Where:

$C_t$ = cash inflow at time t
$C_0$ = initial investment (cash outflow)
$r$ = discount rate (cost of capital)
$t$ = time period

Decision Rule

NPV > 0 → Accept the project (it adds value).
NPV < 0 → Reject the project.
NPV = 0 → Break-even point.

Example

A project requires an initial investment of ₦100,000 and will generate ₦40,000 annually for 3 years. Discount rate = 10%.

NPV = \frac{40,000}{(1+0.1)^1} + \frac{40,000}{(1+0.1)^2} + \frac{40,000}{(1+0.1)^3} - 100,000

NPV = 36,363.6 + 33,057.9 + 30,052.6 - 100,000 = -526

Since NPV is slightly negative, the project should be rejected.

2. Internal Rate of Return (IRR)

Definition

IRR is the discount rate at which the NPV of a project becomes zero. In other words, it is the rate of return that makes present value of cash inflows equal to the initial investment.

Formula

IRR is solved from:

0 = \sum \frac{C_t}{(1 + IRR)^t} - C_0

This usually requires trial-and-error or financial calculators/Excel.

Decision Rule

IRR > Cost of capital → Accept the project.
IRR < Cost of capital → Reject the project.

Example

Using the same project (₦100,000 outflow; ₦40,000 inflow for 3 years), solve for IRR:

We need to find r such that:

100,000 = \frac{40,000}{(1+r)} + \frac{40,000}{(1+r)^2} + \frac{40,000}{(1+r)^3}

Using financial calculator/Excel, IRR ≈ 9.9%.
If the cost of capital is 10%, the project is marginal and may not be worth accepting.

3. Accounting Rate of Return (ARR)

Definition

ARR measures the return on investment based on accounting profits (not cash flows). It is expressed as a percentage of the average investment.

Formula

ARR = \frac{\text{Average Accounting Profit}}{\text{Initial or Average Investment}} \times 100

Decision Rule

ARR > Target rate → Accept the project.
ARR < Target rate → Reject the project.

Example

If a project requires ₦100,000 and generates annual accounting profit of ₦15,000 for 5 years:

ARR = \frac{15,000}{100,000} \times 100 = 15\%

If the company’s required return is 12%, the project is acceptable.

Comparison: NPV vs IRR vs ARR

Feature	NPV	IRR	ARR
Basis of Calculation	Cash flows discounted to present value	Discount rate that makes NPV = 0	Accounting profit
Time Value of Money	Considered	Considered	Ignored
Decision Criterion	Accept if NPV > 0	Accept if IRR > cost of capital	Accept if ARR > target return
Complexity	Requires discount rate	Requires iteration/calculators	Simple to compute
Reliability	More reliable and preferred	Useful, but can be misleading for non-conventional cash flows	Less reliable

✅ In practice:

NPV is generally considered the best method (most realistic).
IRR is widely used but can give conflicting results with NPV.
ARR is easy but less accurate since it ignores time value of money