R02 Cheat Sheet 2025/2026 — Investment Principles & Risk

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Question 1 of 10

LO1Characteristics, inherent risks, behaviour & correlation of asset classes17 standard / 11 multiple response

Asset class risk/return spectrum (lowest → highest risk)

Cash→Gilts→Investment grade bonds→Commercial property→High-yield bonds→UK equities→Global equities→Emerging markets / alternatives

Equities — key ratios

Ratio	Formula	What it tells you
Price/Earnings (P/E)	Share price ÷ EPS	How much investors pay per £1 of earnings. High P/E = high growth expectations.
Dividend yield	(Dividend per share ÷ Share price) × 100	Income return as % of current price
Running yield	(Annual coupon ÷ Clean price) × 100	Income return from a bond at current price
Redemption yield	Running yield ± annual capital gain/loss to maturity	Total return if bond held to maturity

Simplified redemption yield: Annual capital change = (Redemption value − Clean price) ÷ Years to maturity. Example: Clean price £97, coupon £5, 5 years. Capital gain/yr = £0.60. Redemption yield ≈ 5.60/98.50 = 5.69%

Fixed-interest securities

Conventional gilts

UK Government — near-zero default risk
Fixed coupon; fixed redemption value (£100 nominal)
Price and yield move inversely
Clean price excludes accrued interest

Index-linked gilts

Both coupon AND redemption value linked to RPI
Protect against inflation risk
Lower running yield than conventional gilts

Corporate bonds

Issued by companies; carry credit/default risk
Investment grade = BBB− and above
Credit spread = extra yield over gilts of same maturity

Exam trap: The nominal (par) value of a gilt at redemption is always £100 regardless of what you paid.

Correlation

Correlation value	Meaning	Diversification benefit
+1.0	Assets move perfectly together	None
0	No linear relationship	Good
−1.0	Assets move in perfect opposition	Maximum

Stamp Duty & PTM Levy

Tax	Rate	Key rule
SDRT	0.5% of purchase price	Electronic purchase via CREST. AIM shares — exempt.
Stamp Duty	0.5% (rounded up to nearest £5)	Paper stock transfer form. Transactions over £1,000.
PTM Levy	£1.00 flat	CREST transactions over £10,000 only.

LO2Macro-economic environment & its impact on asset classes6 standard format

Inflation types

CPI = official UK measure; excludes housing costs
RPI = includes mortgage interest; used for index-linking
Disinflation = inflation slowing (still positive)
Deflation = falling price level
Stagflation = high inflation + stagnant growth

Policy types

Monetary policy = Bank of England: base rate, QE
Fiscal policy = Government: taxation, spending
Expansionary = lower rates / more spending
Contractionary = higher rates / less spending

Yield curve shapes

Normal (upward) = most common; economic growth expected
Flat = uncertainty / transition
Inverted = historically a reliable recession predictor

Interest rates and asset class impacts

If interest rates RISE →	If interest rates FALL →
Existing bond prices fall	Existing bond prices rise
Sterling may appreciate	Sterling may depreciate
Equity valuations come under pressure	Equity valuations tend to rise
Cash deposits become more attractive	Cash returns fall; investors seek yield elsewhere

LO3Merits & limitations of the main investment theories7 standard format

Efficient Market Hypothesis (EMH)

Form	What prices reflect	Implication
Weak form	All historical price data	Technical analysis cannot consistently beat market
Semi-strong form	All publicly available information	Fundamental analysis cannot consistently beat market
Strong form	All information — including insider information	No one can consistently beat market

CAPM

CAPM formula: Expected return = Risk-free rate + β × (Market return − Risk-free rate)

Example: Risk-free rate 2%, market return 8%, beta 1.3 → Expected return = 2% + 1.3 × 6% = 9.8%

Beta (β)

β = 1: moves with market
β > 1: more volatile than market
β < 1: less volatile than market

Alpha (α)

Excess return above CAPM-predicted return
Positive α = manager has added value
Alpha ≠ simply return minus benchmark

Modern Portfolio Theory

Diversification reduces risk without proportionally reducing return
Systematic risk cannot be diversified away
Non-systematic risk can be diversified away

Behavioural finance biases

Bias	What it means	Investment impact
Overconfidence	Overestimating own ability	Excessive trading, under-diversification
Anchoring	Over-relying on the first piece of information	Refusing to accept a stock has fundamentally changed
Recency bias	Extrapolating recent trends into the future	Chasing recent winners; panic selling after falls
Disposition effect	Selling winners too early; holding losers too long	Poor portfolio outcomes
Loss aversion	Pain of loss felt more acutely than equivalent gain	Overly conservative; avoiding necessary risk
Home bias	Over-weighting domestic investments	Lack of geographic diversification

LO4Time value of money3 standard format

Future Value (compounding)

FV = PV × (1 + r)ⁿ

£5,000 at 4% for 3 years = £5,000 × 1.04³ = £5,624.32

Present Value (discounting)

PV = FV ÷ (1 + r)ⁿ

£14,000 in 4 years at 5% = £14,000 ÷ 1.05⁴ = £11,517.83

AER formula: AER = (1 + r/n)ⁿ − 1
6% compounded quarterly: AER = (1.015)⁴ − 1 = 6.14%

Real return (Fisher equation): Real return = (1 + nominal) ÷ (1 + inflation) − 1
Nominal 7%, inflation 2%: = (1.07 ÷ 1.02) − 1 = 4.90%

LO5Nature & impact of the main types of risk on investment performance5 standard format

Systematic risk (market risk)

Affects the whole market — cannot be diversified away
Measured by beta
Examples: recessions, interest rate changes, political events

Non-systematic risk (specific risk)

Affects specific companies or sectors — CAN be diversified away
At ~15–20 well-diversified holdings, most specific risk is eliminated
Examples: fraud, product recall, management failure

Risk type	Description	Most relevant to
Credit / default risk	Issuer fails to pay coupon or principal	Corporate bonds, especially high-yield
Interest rate / duration risk	Bond prices fall when rates rise. Higher duration = greater sensitivity.	Fixed-income portfolios
Inflation risk	Returns fail to keep pace with inflation	Cash, fixed income
Liquidity risk	Cannot sell investment at fair value quickly	Direct property, small-caps, hedge funds
Currency risk	Exchange rate movements reduce sterling value of overseas returns	International equities, overseas bonds
Reinvestment risk	Coupon payments reinvested at lower rates if rates fall	High-coupon bonds
Counterparty risk	The other party to a contract defaults	Derivatives, structured products
Gearing risk	Borrowing amplifies losses as well as gains	Investment trusts; leveraged investors

Gearing loss calculation: Investor has £8,000 own capital + borrows £2,000 = £10,000 invested. Shares fall 10% → loss = £1,000. After repaying loan, investor has £7,000. Loss on own capital = £1,000/£8,000 = 12.5% (not 10% — gearing amplifies the loss).

LO6Characteristics, risks & tax of investment products15 standard / 7 multiple response

Collective investment structures compared

Feature	Unit trust	OEIC	Investment trust	ETF
Open/closed ended	Open-ended	Open-ended	Closed-ended	Open-ended (typically)
Pricing	Dual (bid/offer)	Single price	Market price	Real-time on exchange
Discount/premium to NAV?	No	No	Yes	Very small
Gearing permitted?	No	No	Yes	Some

Investment trust discount: "A significant discount to NAV" is a characteristic of investment trusts only — not unit trusts or OEICs.

Investment bonds — onshore vs offshore

Feature	Onshore bond	Offshore bond
Tax within fund	Tax paid at ~20% within fund	Gross roll-up — minimal tax within fund
5% withdrawal allowance	Yes — deferred until surrender	Yes — same rule
Basic-rate taxpayer on surrender	No further liability (20% deemed paid)	20% tax payable (no credit)
Higher-rate taxpayer	20% additional (40%−20% credit)	40% liability (no credit)
Assignment as gift — chargeable event?	Yes	No

EIS, SEIS and VCT

Feature	EIS	SEIS	VCT
IT relief	30% (max £1m)	50% (max £200,000)	30% (max £200,000)
Min holding for IT relief	3 years	3 years	5 years
CGT on disposal	Exempt after 3 years	Exempt after 3 years	Exempt
CGT deferral	Yes	No	No
Dividends	Taxable	Taxable	Tax-free
IHT Business Relief	After 2 years	After 2 years	No

Offshore funds — reporting vs non-reporting

Fund type	Gains on disposal taxed as	Rate
Reporting fund	Capital gain (CGT)	18% / 24%
Non-reporting fund	Income (offshore income gain)	Up to 45%

Non-reporting offshore fund gains = taxed as income, not CGT. Higher-rate taxpayer pays 40%/45% vs 24% on a reporting fund.

FSCS protection limits

Type of claim	Protection limit
Bank/building society deposits	£85,000 per person per authorised institution
Temporary high balances	£1,000,000 for up to 6 months
Investment business	£85,000
Insurance (long-term)	100% of the claim
NS&I products	100% — backed by HM Treasury

LO7Applying the investment advice process11 standard format

Attitude to risk ≠ capacity for loss. A client may feel brave (high attitude to risk) but have very little financial buffer (low capacity for loss). The adviser must use the lower of the two.

Investment management styles

Style	Approach
Active management	Manager uses judgement to outperform benchmark. Higher charges. Potential to add alpha.
Passive / index tracking	Replicates a market index. Lower charges. Tracks the market.
Value	Buys undervalued securities with low P/E ratios
Growth	Invests in companies with above-average earnings growth expectations
Momentum	Invests in securities with strong recent price performance
Contrarian	Buys assets currently out of favour, betting on sentiment reversal

Pound cost averaging: Investing a fixed amount at regular intervals. Does NOT guarantee a lower average price. Primary benefit: reduces risk of poor market timing.

Ethical investment

Approach	Description
Negative screening	Excluding companies in specific sectors (armaments, tobacco). "Dark green" = strict exclusions.
Positive screening	Actively seeking companies with strong ESG performance
ESG integration	Incorporating environmental, social and governance factors into mainstream analysis
Engagement / stewardship	Using shareholder voting rights to influence company behaviour

LO8Principles of investment planning8 standard format

Strategic asset allocation (SAA)

The long-term target allocation, based on the client's objectives, risk profile and time horizon. Represents the benchmark position.

Tactical asset allocation (TAA)

Short-term deviations from the strategic allocation to exploit market opportunities. Returns to SAA when opportunity passes.

Rebalancing: If a portfolio drifts from its target allocation (e.g. equities rise from 60% to 72%), sell equities and buy bonds to restore the 60% target. Applies in both accumulation and decumulation phases.

Core-satellite approach: Low-cost passive fund forms the stable core. Active, specialist or higher-risk funds form satellites — balancing cost efficiency with targeted outperformance potential.

Fettered fund of funds

Invests only within the same fund group
Potentially lower charges
Limited manager diversity

Unfettered fund of funds

Can invest across any fund group
Greater manager and style diversity
Potentially higher charges (dual layer of fees)

OCF vs PTR: OCF = annual running cost as % of assets. Does NOT include dealing/transaction costs. PTR captures transaction activity. A fund can have low OCF but high PTR — they are independent.

LO9Analysing the performance of investments10 multiple response

Risk-adjusted performance measures

Measure	Formula	Risk measure used	Best used when
Sharpe ratio	(Portfolio return − Risk-free rate) ÷ Standard deviation	Total risk	Comparing portfolios with different total risk levels
Treynor ratio	(Portfolio return − Risk-free rate) ÷ Beta	Systematic risk	Comparing well-diversified portfolios
Information ratio	(Portfolio return − Benchmark return) ÷ Tracking error	Active risk	Evaluating active management skill
Jensen's alpha	Actual return − CAPM expected return	Systematic risk	Measuring manager value-add vs market risk taken

Higher is better for all four measures. Only the information ratio does NOT need the risk-free rate. Sharpe uses standard deviation (total volatility). Treynor uses beta (systematic risk only).

Sharpe ratio example

Portfolio return: 12%
Risk-free rate: 2%
Standard deviation: 8%

Sharpe = (12% − 2%) ÷ 8% = 1.25

Information ratio example

Portfolio return: 9%
Benchmark return: 7%
Tracking error: 4%

IR = 2% ÷ 4% = 0.50

TWR vs MWR

Measure	What it captures	Best used for
Time-weighted return (TWR)	Performance of the fund itself — unaffected by timing of cash flows	Comparing fund managers
Money-weighted return (MWR)	The actual return experienced by the specific investor	Measuring what a specific client actually achieved

FIGURESKey figures & tax tables 2025/2026Provided in exam

Income tax & CGT 2025/2026

£12,570

Personal Allowance

20%

Basic rate (£0–£37,700)

40%

Higher rate (£37,701–£125,140)

45%

Additional rate (£125,141+)

£3,000

CGT annual exemption (individuals)

18%

CGT — basic rate

24%

CGT — higher/additional rate

14%

BADR rate from Apr 2025

ISA limits 2025/2026

£20,000

Adult ISA annual limit

£9,000

Junior ISA annual limit

£4,000

Lifetime ISA max annual contribution

25%

LISA government bonus (max £1,000/yr)

Common R02 exam traps

Trap question	Correct answer
Does a significant discount to NAV indicate an investment trust or unit trust?	Investment trust only
Non-reporting offshore fund — how are gains taxed?	As income at marginal rate (NOT CGT)
Alpha vs. excess return over benchmark?	Alpha ≠ simple outperformance. Alpha is outperformance adjusted for the level of market risk taken (via CAPM)
Does the OCF include dealing/transaction costs?	No — OCF excludes dealing costs
Sharpe ratio uses beta or standard deviation?	Standard deviation. Treynor uses beta.
VCT dividends — taxable?	Tax-free — one of the key VCT benefits (unlike EIS)
Information ratio — does it require the risk-free rate?	No — only benchmark return and tracking error needed
PTM levy rate on a £12,000 CREST transaction?	£1.00 flat
Currency-hedged share class — does it remove currency risk?	Reduces — does not guarantee full elimination

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Investment Principles & Risk — All 9 Learning Outcomes