Investment Planning
Domain 3 tests asset allocation, risk and return measurement, diversification, and the discipline of an investment policy statement (IPS). Expect questions that require you to choose an allocation from client facts, not from market forecasts.
Core rules
- The IPS records objectives, return requirement, risk tolerance and capacity, time horizon, liquidity needs, tax position, legal constraints, and review trigger.
- Risk tolerance is willingness; risk capacity is financial ability to bear loss. The lower of the two governs.
- Diversification reduces unsystematic risk; correlation determines how much. Low or negative correlation improves risk-adjusted return.
- Expected portfolio return = weighted average of asset returns: Σ wᵢrᵢ.
- Sharpe ratio = (portfolio return − risk-free rate) / standard deviation. Higher is better.
- CAPM: required return = risk-free rate + beta × market risk premium.
- Rebalancing controls drift; costs and taxes may justify bands rather than calendar rebalancing.
Worked example
A portfolio is 60% equities with expected return 8% and 40% bonds with expected return 4%. Expected return = 0.6 × 8% + 0.4 × 4% = 6.4%. If the portfolio standard deviation is 10% and the risk-free rate is 2%, the Sharpe ratio is (6.4% − 2%) / 10% = 0.44. If annual fees are 1%, the net return is 5.4% and the Sharpe ratio falls to 0.34. With 2.5% inflation, the real return is approximately (1.054 / 1.025) − 1 = 2.8%. The planner should show the client both gross and net figures and explain that fees reduce the return without reducing risk.
Traps
- Treating a high risk tolerance as permission to ignore a short time horizon or liquidity need.
- Chasing recent top-performing funds; past returns are not a forecast.
- Ignoring correlation and calling any multi-fund portfolio diversified.
- Comparing returns without adjusting for risk, fees, or taxes.
- Placing tax-inefficient assets in taxable accounts when tax-advantaged space is available.
- Rebalancing so often that costs exceed the benefit.