Portfolio Management and Wealth Planning
Domain 8 - Portfolio Management and Wealth Planning
This domain tests risk aversion, portfolio construction, asset pricing, investment policy statements, and performance evaluation. Questions often ask you to compute a portfolio return or risk measure, or to identify the constraint that drives an allocation decision.
Core rules
- Risk and utility: Investors trade off expected return and risk. A risk-averse investor requires higher expected return to accept higher variance.
- Modern portfolio theory: Diversification reduces unsystematic risk. The efficient frontier contains portfolios with the highest expected return for a given risk. The capital allocation line combines the risk-free asset with the tangency portfolio.
- CAPM: Required return = risk-free rate + beta × market risk premium. Beta measures systematic risk; unsystematic risk is not compensated in equilibrium.
- IPS: An investment policy statement states objectives (return and risk), constraints (liquidity, time horizon, tax, legal, unique), and rebalancing and review procedures.
- Performance: Time-weighted returns remove the effect of cash flows; money-weighted returns reflect the investor's actual cash-flow timing.
Worked example
A portfolio has expected return 11%, beta 1.2, and standard deviation 18%. The risk-free rate is 3%, and the expected market return is 9%. CAPM required return is 3% + 1.2 × (9% - 3%) = 3% + 7.2% = 10.2%. Jensen's alpha is 11% - 10.2% = 0.8%, so the portfolio earned 0.8% above its systematic-risk-adjusted required return. The Sharpe ratio would use total risk: (11% - 3%) / 18% = 0.444. A high alpha does not mean the portfolio is low-risk; it means the return exceeded the CAPM benchmark for its beta.
Traps that cost marks
- Using standard deviation instead of beta in the CAPM.
- Comparing a time-weighted return with a money-weighted return as if they measure the same thing.
- Ignoring liquidity and tax constraints in an IPS.
- Treating the Sharpe ratio as appropriate for a well-diversified portfolio only.
- Confusing arithmetic average return with geometric compound return.