Portfolio Management and Asset Allocation
The Portfolio Management and Asset Allocation domain tests how risk and return combine in a portfolio, how allocation decisions are made and judged, and how performance is attributed. Expect quantitative work on portfolio risk, beta and Sharpe ratio, plus qualitative reasoning on investment policy.
Core theory
- Expected portfolio return is the weighted average of asset returns; portfolio volatility is not, because of diversification. Volatility depends on weights, individual volatilities and pairwise correlations.
- The efficient frontier is the set of portfolios giving maximum return for each risk level; adding a risk-free asset produces the Capital Market Line and the tangency portfolio.
- CAPM: E(R) = Rf + β(E(Rm) − Rf). Beta captures systematic risk only; idiosyncratic risk is diversifiable and uncompensated.
Process
- The investment policy statement fixes objectives, return requirement, risk tolerance, horizon, liquidity needs, tax and legal constraints, and the benchmark.
- Strategic allocation follows long-term policy; tactical tilts stay within written limits. Rebalancing rules - calendar, threshold or hybrid - must be documented.
- Time-weighted returns strip out cash-flow timing; money-weighted returns (IRR) reflect the client's actual experience. Attribution splits return into allocation and selection effects.
Worked example
Portfolio: 60% equities (expected return 8%, volatility 15%), 40% bonds (3%, 5%), correlation 0.2. Expected return = 0.6 × 8 + 0.4 × 3 = 6.0%. Variance = 0.36 × 225 + 0.16 × 25 + 2 × 0.6 × 0.4 × 0.2 × 15 × 5 = 81 + 4 + 7.2 = 92.2, so volatility = 9.60%. Adding bonds gave up 2 points of expected return but cut volatility by about 5.4 points against 100% equity; the 7.2 covariance term is the diversification benefit, and it vanishes at correlation 1.
Traps
- Averaging volatilities instead of computing the covariance terms.
- Mixing percentage and decimal inputs in the variance formula.
- Ranking funds on raw return rather than risk-adjusted measures such as Sharpe or information ratio.
- Choosing a benchmark that does not match the mandate, making attribution meaningless.
- Using time-weighted returns to discuss a client's cash-flow experience.