Investment Planning and Asset Allocation
This domain tests investment policy statements, asset allocation, risk and return measurement, diversification, correlation, rebalancing, costs, taxes, and behavioral biases. Questions often ask what allocation suits a time horizon or risk capacity, why a portfolio's risk is not the weighted average of its holdings, and how fees and taxes erode returns.
Core rules and concepts
- The investment policy statement states objectives, return requirement, risk tolerance, time horizon, liquidity needs, tax status, legal constraints, and review procedures. Risk tolerance is emotional willingness; risk capacity is financial ability to bear loss.
- Expected portfolio return is the weighted average of asset returns. Portfolio risk is not the weighted average unless correlation is +1; correlation below +1 reduces volatility through diversification.
- Diversification reduces unsystematic risk, not systematic market risk. Asset allocation is the primary driver of return variability; security selection and market timing are secondary.
- Rebalancing to target weights controls drift and risk. Calendar, threshold, and hybrid approaches are common; bands reduce trading costs.
- Costs compound: a 1% fee can consume a large share of terminal wealth over decades. Tax location matters: tax-inefficient assets belong in tax-deferred accounts where possible.
- Behavioral biases include loss aversion, recency, overconfidence, anchoring, and herd behavior. The planner's job is to align the portfolio with the IPS, not with the latest headline.
Worked example
A 60/40 portfolio has expected returns of 8% and 3%, standard deviations of 14% and 5%, and correlation of 0.10. Expected return is 0.60(8) + 0.40(3) = 6.0%. Variance is (0.60^2)(14^2) + (0.40^2)(5^2) + 2(0.60)(0.40)(0.10)(14)(5) = 70.56 + 4.00 + 3.36 = 77.92, so standard deviation is about 8.83%. The weighted-average standard deviation would be 10.4%, but correlation below +1 lowers portfolio risk. Reasoning: the allocation, not either asset alone, determines the risk-return profile.
Traps that cost marks
- Confusing asset allocation with security selection.
- Assuming diversification eliminates all risk.
- Using past returns as a guarantee.
- Ignoring correlation and rebalancing.
- Overlooking fees, taxes, and turnover.
- Treating risk tolerance and risk capacity as the same.