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FPWMP: Investment Planning and Asset Allocation

FPWMP · Work through your exam, one topic at a time.

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Investment Planning and Asset Allocation

Investment Planning and Asset Allocation

This domain tests whether you can convert objectives and constraints into a policy statement, then a portfolio, and defend it with risk-adjusted evidence rather than past performance.

The investment policy statement

Objectives: required return and acceptable risk, both stated numerically. Constraints: liquidity, time horizon, tax, legal and regulatory, and unique circumstances.

Concepts tested

  • Expected portfolio return is the weighted average of asset returns. Portfolio risk is not: correlation below 1 produces a diversification benefit.
  • Standard deviation measures total volatility; beta measures sensitivity to the market. Sharpe ratio = (return − risk-free) ÷ standard deviation; higher is better, and it only compares portfolios with similar mandates.
  • Strategic allocation is the long-run policy mix and explains most of return variability; tactical tilts are short-term and should be bounded.
  • Rebalancing enforces sell-high/buy-low. Calendar and threshold triggers (for example ±5% bands) both work; threshold is usually more efficient.
  • Asset location: hold interest-bearing assets in tax-deferred accounts and tax-efficient assets in taxable accounts where the jurisdiction allows.

Worked example

A client holds 60% equities (expected 8%, standard deviation 16%) and 40% bonds (expected 3%, standard deviation 6%); risk-free rate 2%. Expected return = 0.6 × 8 + 0.4 × 3 = 6.0%. With correlation 0.15, variance = 0.36 × 256 + 0.16 × 36 + 2 × 0.6 × 0.4 × 16 × 6 × 0.15 = 92.16 + 5.76 + 6.91 = 104.83, so standard deviation is about 10.2% - well below the 12% weighted average of the two risks. That gap is diversification, and it is the number to show a nervous client. Sharpe = (6 − 2) ÷ 10.2 = 0.39.

Traps that cost marks

  • Extrapolating recent returns instead of using long-run capital market assumptions.
  • Ignoring the true horizon and capacity, so a temporary drawdown forces a sale at the bottom.
  • Confusing a high Sharpe ratio with suitability - it says nothing about goal funding.
  • Quoting gross returns without fees and taxes, which can remove a third of the return over decades.
  • Rebalancing only in calm markets and abandoning it during stress.