Investment Planning
Investment Planning blends portfolio theory, product knowledge and performance measurement. Questions typically ask you to choose between two portfolios, interpret a statistic, or spot a suitability failure.
Risk and return
- Total risk = systematic + unsystematic. Unsystematic risk is diversifiable; systematic (market) risk is not.
- Standard deviation measures total volatility. Beta measures sensitivity to the market, so it captures systematic risk only.
- Correlation drives diversification: the lower the correlation between holdings, the greater the benefit. Adding 20 Canadian equity funds gives you almost no diversification.
- CAPM: E(R) = Rf + β(Rm − Rf).
- Duration estimates a bond's price change for a 1% move in yields; longer duration means more interest-rate risk.
Products to recognise
Mutual funds (MER embedded in returns; deferred sales charges banned in Canada since 2022), ETFs, segregated funds (75% maturity and 100% death guarantees, creditor protection with an irrevocable beneficiary), GICs, preferred shares (rate-reset and dividend features), and options (covered call caps upside; protective put sets a floor).
Measuring performance
- Time-weighted return strips out the effect of client cash flows and is the fair measure of a manager.
- Money-weighted return is the IRR and reflects what the investor actually earned.
- Sharpe ratio = (Rp − Rf) / σ; higher is better on a risk-adjusted basis.
Worked example
Fund A returns 9% with σ of 12%. Fund B returns 11% with σ of 18%. Risk-free rate is 3%.
Sharpe A = (9 − 3) / 12 = 0.50. Sharpe B = (11 − 3) / 18 = 0.44.
Fund B has a higher raw return but took disproportionately more risk; on a risk-adjusted basis Fund A is superior. If the client cannot tolerate drawdowns, A is also the suitability answer.
Behavioural finance
Loss aversion (losses hurt roughly twice as much as equivalent gains please), anchoring to purchase price, recency bias, overconfidence, mental accounting and home bias all produce predictable client errors. The exam asks you to name the bias and give a corrective process - not to lecture.
Traps
- Using beta as a measure of total risk, or σ as a measure of market risk.
- Comparing raw returns without adjusting for risk.
- Assuming seg fund guarantees apply on any redemption, rather than at maturity or death.
- Confusing time-weighted and money-weighted returns when the client made large contributions.
- Ignoring that MER is already netted out of published fund returns.