Investment Planning: risk measurement, asset classes, wrappers and behavioural bias
Investment Planning tests how a client's objectives, attitude to risk and capacity for loss become a suitable portfolio, and whether you can justify the result in numbers. Expect risk measurement, asset-class behaviour, product structures, wrappers and behavioural bias.
Risk, return and diversification
Total return combines income and capital growth. Risk is usually measured as the standard deviation of returns, and the Sharpe ratio divides excess return by that volatility: (portfolio return − risk-free rate) ÷ standard deviation. Beta measures sensitivity to the market; alpha is the return not explained by market exposure. Diversification reduces unsystematic, company-specific risk but not systematic market risk, and its power depends on correlation rather than the number of holdings. Modern portfolio theory produces the efficient frontier: the highest expected return available for each level of risk.
Asset classes
Cash is capital-certain but loses to inflation. Gilt and corporate bond prices move inversely to yields; longer duration means more sensitivity, and credit spreads widen in stress. Index-linked gilts hedge inflation but real yields still move. Equities offer the highest expected long-run return with the widest dispersion. Property is illiquid with valuation lag; alternatives offer lower correlation but variable liquidity. Attitude to risk (willingness) and capacity for loss (ability to absorb a fall without derailing goals) are assessed separately and both must be satisfied.
Products and wrappers
OEICs and unit trusts are open-ended and single-priced; investment trusts are closed-ended, can trade at a premium or discount and may gear. ETFs trade intraday and may replicate synthetically. ISAs shelter £20,000 a year; pensions give relief on entry and are taxed on exit; onshore bonds suffer 20% tax within the fund, with chargeable events and 5% cumulative withdrawals; VCTs, EIS and SEIS offer income tax and CGT reliefs in exchange for higher risk.
Worked example
Jon invests £50,000; a year later it is worth £54,500 and he has received £1,200 of dividends. Total return is (54,500 + 1,200 − 50,000) ÷ 50,000 = 11.4%. With a 4% risk-free rate and 12% standard deviation, the Sharpe ratio is (11.4 − 4) ÷ 12 = 0.62. The raw 11.4% says nothing about the risk taken; the Sharpe ratio makes comparison with alternative portfolios meaningful.
Traps that cost marks
- Mixing attitude to risk with capacity for loss.
- Comparing funds on quoted yield while ignoring fund charges, platform fees and adviser charges.
- Assuming an investment trust discount must narrow.
- Treating the 5% bond withdrawal as tax-free - it is a deferral, cumulative to 100% of premiums.
- Extrapolating recent or back-tested performance into a recommendation.