Portfolio Construction, Asset Allocation and Risk Management
What a candidate must understand
Portfolio construction starts with the investment policy statement: objectives, risk tolerance, time horizon, liquidity needs and constraints. Know strategic asset allocation (long-term target weights) versus tactical asset allocation (short-term deviations). Understand diversification and correlation: combining assets with less than perfect correlation reduces portfolio risk without necessarily reducing return. Cover expected return, standard deviation and the efficient frontier, and the capital asset pricing model: expected return = risk-free rate + beta × market risk premium. Distinguish systematic (market) risk, which cannot be diversified away, from unsystematic risk, which can. Know Sharpe ratio (excess return per unit of total risk) and beta (sensitivity to market moves). Risk management includes rebalancing, stop-loss discipline, VaR as a probabilistic loss estimate, and stress testing.
Traps that appear in questions
- Assuming diversification eliminates all risk; systematic risk remains.
- Confusing beta (market sensitivity) with standard deviation (total volatility).
- Treating a high past return as a guarantee; mean reversion and survivorship bias distort comparisons.
- Forgetting that rebalancing enforces buy-low/sell-high discipline.
- Misreading VaR as a maximum possible loss rather than a threshold at a confidence level.
Worked example / rule of thumb
Risk-free 3%, beta 1.2, market premium 6%. Expected return = 3% + 1.2 × 6% = 10.2%. Rule of thumb: diversify away what you can, price what you cannot - unsystematic risk is diversifiable, systematic risk is compensated.