Investment Planning
Portfolio theory
Expected return, standard deviation, and correlation drive construction. Diversification eliminates unsystematic risk; systematic (market) risk is measured by beta and cannot be diversified away. CAPM: E(R) = Rf + β(Rm − Rf). The efficient frontier plots the best return for each risk level; the capital market line adds the risk-free asset.
Performance measurement
- Holding period return = (ending value − beginning value + income) ÷ beginning value
- Time-weighted return measures manager skill; dollar-weighted (IRR) measures the investor's experience.
- Sharpe ratio = (Rp − Rf) ÷ σp; higher is better.
- Geometric mean is always ≤ arithmetic mean and describes realized compound growth.
Fixed income and equity
Bond prices move inversely to yields; duration approximates the percentage price change for a 1% yield change. Dividend discount model: P0 = D1 ÷ (r − g).
Traps
- Beta measures only systematic risk; standard deviation measures total risk.
- A correlation of −1 gives the greatest diversification benefit - not zero.
- Compare funds on expense ratio, turnover, and tax efficiency, not past return alone.
- Behavioral biases (loss aversion, recency, anchoring, mental accounting, overconfidence) appear as "the client wants to sell after a decline."
Worked example. A portfolio returns 10%, T-bills yield 3%, and portfolio standard deviation is 12%. Sharpe = (10 − 3) ÷ 12 = 0.58. A rival with the same return and 20% volatility scores 0.35, so the first is superior on a risk-adjusted basis.