A company announces a 2-for-1 stock split. Your client calls in a panic: "They cut my stock price in half!" You need to explain that nothing changed, the total value is identical. That conversation is the Series 7 in miniature: knowing the mechanics behind equity securities, the ratios that measure them, and the corporate actions that reshape them.
Every investment carries two layers of risk. Systematic risk affects the entire market. Interest rate changes, inflation, recessions, geopolitical events, these hit all securities. You cannot diversify them away no matter how many stocks you hold.
Nonsystematic risk is specific to one company or industry. A CEO resigns. A factory burns down. A lawsuit hits. You reduce this risk by spreading your money across different companies, industries, and asset classes. That is diversification.
KEY: Diversification eliminates nonsystematic risk. It does nothing to systematic risk. If a question asks what risk diversification removes, the answer is always nonsystematic (also called unsystematic, company-specific, or business risk).
Common mistakes
- Forgetting to subtract preferred dividends from EPS. Net income of $5,000,000 with $500,000 preferred dividends and 1,000,000 shares gives EPS of $4.50, not $5.00. The trap answer $5.00 appears on nearly every EPS question. Always ask: are there preferred dividends?
- Confusing systematic and nonsystematic risk. Interest rate risk, inflation risk, and market risk are systematic, they affect everything and cannot be diversified away. Business risk, financial risk, and regulatory risk for a single company are nonsystematic. The exam rotates through different risk names to test whether you know which category each belongs to.
- Using the annual dividend instead of the quarterly dividend for ex-date price adjustment. A stock at $52 paying $0.50 quarterly opens at $51.50 on the ex-date, not $50.00. The $50 answer uses the annual dividend of $2.00. The adjustment equals the declared dividend for that period only.
Bottom line
- Systematic risk cannot be diversified away (interest rate, inflation, market risk); nonsystematic risk (business, financial, regulatory) can be diversified.
- Beta measures market sensitivity: beta 1.0 moves with the market, beta above 1.0 is more volatile (beta 1.5 = 50% more volatile).
- EPS = (Net Income - Preferred Dividends) / Common Shares Outstanding; always subtract preferred dividends first.
- Cumulative preferred accumulates missed dividends that must be paid before common resumes, but it never forces payment on a set date.
Exam shortcut
When the exam asks what diversification eliminates, pick the answer with "nonsystematic," "unsystematic," "company-specific," or "business risk." If it says "market risk" or "interest rate risk," that is systematic and cannot be diversified away. For EPS, always check for preferred dividends. If the question mentions preferred stock at all, subtract those dividends. The trap answer that skips this step will always be one of the choices.
The full lesson (about 3,430 words, 23 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- C11
- C12
- C13
- C14
- C15
- C16
- C17
- C18
- C19
- C20
- C21
- C22
- C23
- C24
- C25
- C26
- C27
- C28
- C29
- C30
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