Risk and Return Analysis, and Asset Allocation
Risk and Return Analysis, and Asset Allocation
This domain tests whether you can measure return and risk correctly and use correlation to build portfolios, not just pick assets.
Return and risk
- Holding-period return = (ending value − beginning value + income) / beginning value.
- Arithmetic vs. geometric mean: arithmetic averages single-period returns; geometric (CAGR) reflects compounded wealth and is lower when returns are volatile.
- Risk measures: standard deviation (total volatility), beta (sensitivity to the market), downside deviation, credit risk, and liquidity risk.
- CAPM: expected return = risk-free rate + beta × market risk premium. Beta measures systematic risk, not total risk.
Allocation
- Strategic allocation sets long-term policy targets; tactical allocation makes short-term deviations within policy limits.
- Diversification works through imperfect correlation, not through holding many similar funds.
- Rebalancing controls drift and risk; it is not a return forecast.
Worked example
A portfolio is 50% equity (expected return 8%, SD 20%) and 50% bonds (expected return 3%, SD 5%). Expected return = 0.5 × 8% + 0.5 × 3% = 5.5%. With correlation 0, variance = 0.25 × 0.04 + 0.25 × 0.0025 = 0.010625, so SD = 10.3%. The weighted-average SD would be 12.5%; the lower portfolio SD shows the diversification benefit from low correlation.
Traps
- Using the arithmetic mean for long-horizon compounding.
- Treating low correlation as zero risk.
- Confusing beta with standard deviation.
- Rebalancing only when markets fall, or never.
- Ignoring fees and taxes, which reduce net return.