Portfolio Management and Wealth Planning
Portfolio Theory
Portfolio management applies risk–return optimization. Understand expected return, variance, covariance, and correlation. Diversification reduces unsystematic risk; systematic risk remains. The efficient frontier plots optimal risk–return combinations, and the capital market line introduces the risk-free asset and the Sharpe ratio: (Rp − Rf)/σp. The capital asset pricing model extends this to required returns.
Risk Measures
Know standard deviation (total risk), beta (systematic risk), and downside measures. Understand the security market line and how mispricing appears as alpha (actual return minus CAPM-implied return).
Wealth Planning
Wealth planning integrates goals-based investing, asset allocation, tax efficiency, and estate considerations. Understand the investment policy statement (IPS): objectives (return and risk), constraints (liquidity, time horizon, tax, legal, unique). Rebalancing maintains target weights; strategic allocation reflects long-term policy while tactical tilts exploit short-term views.
Common Traps
- Assuming low-correlation assets always reduce risk regardless of return.
- Confusing the efficient frontier (risky assets only) with the capital market line (includes risk-free).
- Ignoring constraints in the IPS when recommending an allocation.
- Treating beta as total risk (it is systematic only).
Worked Example
A portfolio returns 12% with standard deviation 15%; the risk-free rate is 3%. Sharpe = (12% − 3%) / 15% = 0.60. If a peer portfolio returns 10% with 10% volatility, its Sharpe = 0.70-higher risk-adjusted performance despite lower raw return.