Investment Planning and Portfolio Management
Allocation dominates
Asset allocation explains most of a diversified portfolio's return variability. Understand mean-variance optimization, the efficient frontier, correlation, and the practical critique: inputs are estimates, so prefer robust allocations over corner solutions, and add constraints for liquidity, taxes, and concentration.
Return math you must own
Distinguish arithmetic from geometric (compound) return; volatility drag grows with variance. Sharpe ratio measures excess return per unit of total risk; tracking error measures deviation from a benchmark. Know that diversification fails precisely when correlations converge in a crisis - stress-test, don't assume.
Taxes and location
Asset location places tax-inefficient income producers (taxable bonds, REITs) in tax-deferred accounts and tax-efficient equity index funds in taxable accounts, subject to expected returns and the step-up at death. Tax-loss harvesting adds value mainly through deferral and rate arbitrage, not elimination.
Traps
- Asserting that higher risk guarantees higher return over any horizon.
- Comparing pre-tax returns across accounts with different tax treatment.
- Ignoring concentrated low-basis stock and its risk/correlation to the client's human capital.
- Using a benchmark the client cannot actually access, or that mismatches the mandate.
- Overlooking alternatives' illiquidity, valuation lags, and fee drag.
Rule of thumb
Rebalance when an asset class drifts more than 5 percentage points absolute or 20% relative to target, and revisit the IPS annually. For a concentrated position, quantify the position as a share of total net worth including human capital.
Worked example
A portfolio targets 60% equity with 12% expected return and 15% volatility. Approximate geometric return ≈ 12% − (0.15²)/2 = 12% − 1.125% ≈ 10.9%. Use this to keep return assumptions honest when projecting goals.