Investment Planning and Asset Allocation
Risk, Return, and Diversification
Investment planning connects client objectives to portfolios. Candidates must understand risk tolerance versus risk capacity, expected return, standard deviation as a measure of volatility, and correlation as the engine of diversification. Know that systematic risk (market) cannot be diversified away while unsystematic risk can. Understand the efficient frontier, the capital asset pricing model concept of beta, and the distinction between active and passive management.
Asset Allocation and Rebalancing
Asset allocation is the primary driver of portfolio variability. Strategic allocation reflects long-term targets; tactical allocation makes short-term deviations. Understand rebalancing methods (calendar, threshold, hybrid) and the tax consequences of rebalancing in taxable accounts. Know the role of time horizon, liquidity needs, and tax location: tax-inefficient assets belong in tax-advantaged accounts.
Traps in Exam Questions
A common trap is treating a high stated risk tolerance as permission to ignore a short time horizon. Capacity constrains tolerance. Another trap is confusing standard deviation with loss; it measures dispersion. Watch for questions that recommend concentrating in employer stock for loyalty, or that chase recent performance. Also watch for the assumption that past returns predict future returns, and for ignoring fees, which reduce net return directly.
Worked Example
A client has a 30-year horizon, stable income, and high risk tolerance, so an 80/20 equity-bond allocation is defensible. But $80,000 of the portfolio is needed for a home down payment in two years. The planner carves out that $80,000 into short-term, high-quality instruments and applies the 80/20 allocation only to the remaining long-horizon assets. This separates goals by horizon rather than applying one allocation to all assets.
Rule of Thumb
Match the asset to the goal's time horizon; money needed within three years does not belong in equities.