Investment Planning and Asset Allocation
Investment Planning and Asset Allocation
This domain tests portfolio construction: translating the IPS into a strategic asset allocation, quantifying risk and return, and measuring results against policy. Questions often combine Modern Portfolio Theory, correlation, the efficient frontier, CAPM, and rebalancing rules.
Core rules
- Expected portfolio return is the weighted average of asset returns: E(Rp) = Σ wi E(Ri).
- Portfolio risk is not the weighted average of standard deviations. It depends on correlation: σp = sqrt(ΣΣ wi wj σi σj ρij). Lower correlation reduces risk for the same return.
- The efficient frontier plots portfolios offering the highest expected return for each level of risk. The optimal portfolio depends on the client's risk tolerance and constraints, not on the frontier alone.
- CAPM: E(Ri) = Rf + βi[E(Rm) − Rf]. Beta measures systematic risk; unsystematic risk is diversifiable.
- Sharpe ratio = (Rp − Rf)/σp. It measures excess return per unit of total risk; use it to compare portfolios with similar mandates.
- Strategic allocation is policy; tactical allocation is a deliberate short-term deviation with limits. Rebalance by calendar or by threshold (for example, ±5 percentage points or ±20% relative drift).
- Asset location: place tax-inefficient assets in tax-advantaged accounts where rules permit, but do not let the tax tail wag the allocation dog.
Worked example
A 60/40 portfolio has expected returns of 8% and 3%, standard deviations of 15% and 5%, and correlation 0.2. Expected return = 0.6(8) + 0.4(3) = 6.0%. Variance = (0.6²)(15²) + (0.4²)(5²) + 2(0.6)(0.4)(0.2)(15)(5) = 81 + 4 + 14.4 = 99.4; σp = 9.97%. The diversification benefit is visible: 9.97% is far below the 11% weighted-average standard deviation.
Traps
Using arithmetic instead of geometric returns for long horizons; assuming low correlation means no correlation; confusing Sharpe with a return forecast; ignoring rebalancing costs and taxes; and letting recent performance drive strategic allocation.