Portfolio Management and Asset Allocation
Core concepts
Portfolio management connects client objectives to a constructed mix of assets. Understand the investment policy statement (IPS) - objectives (return and risk), constraints (liquidity, time horizon, tax, legal, unique), and rebalancing rules. Know modern portfolio theory: diversification, correlation, the efficient frontier, and the risk-return tradeoff. Distinguish strategic allocation (long-term target) from tactical allocation (short-term tilts). Understand asset location (which account holds which asset for tax efficiency) and rebalancing (calendar vs. threshold). Be able to discuss active versus passive management and the role of fees.
Traps in questions
Examiners test diversification limits - adding assets with high correlation does little to reduce risk; only low or negative correlation helps. Watch for confusing asset allocation (the mix) with security selection (which specific holdings), and risk tolerance (willingness) with risk capacity (ability). A client may be willing to take more risk than their financial situation allows; the binding constraint is the lower of the two.
Worked rule of thumb
When combining two assets, portfolio risk depends heavily on correlation. If two assets each have 10% volatility and are perfectly correlated, combined volatility is 10%; if perfectly negatively correlated, it approaches 0%. So the diversification benefit is greatest when correlation is low. For rebalancing, a common threshold rule is to rebalance when a holding drifts more than a set band (e.g., 5 percentage points) from target.
Exam strategy
Always anchor recommendations to the IPS; a 'good' portfolio that ignores the client's constraints is the wrong answer.