Investment Planning
Risk and return
Expected return compensates for risk. Know systematic (market) versus unsystematic (diversifiable) risk; diversification reduces the latter. Beta measures sensitivity to market movements; standard deviation measures total volatility. The security market line and CAPM relate required return to beta.
Asset classes and allocation
Understand stocks, bonds, cash, real estate, and alternatives, and how correlation drives diversification. Asset allocation is the primary driver of portfolio variability. Rebalancing restores target weights.
Modern portfolio theory
The efficient frontier shows portfolios offering the highest return for a given risk. Adding a low-correlation asset can reduce portfolio risk without sacrificing return.
Measuring performance
Know time-weighted (manager skill) versus dollar-weighted (investor experience) returns, and risk-adjusted measures such as the Sharpe ratio (excess return per unit of total risk) and the Treynor ratio (per unit of beta).
Worked example
A portfolio returns 10% with a 4% risk-free rate and 12% standard deviation. Sharpe = (10 − 4) / 12 = 0.50. If another portfolio returns 9% with 8% standard deviation, its Sharpe is 0.625, which is superior on a risk-adjusted basis despite the lower raw return.
Traps
Questions test whether a measure uses total risk (standard deviation) or systematic risk (beta), and confuse nominal with real returns.