Investment planning and asset allocation
What the exam tests
Domain 5 covers risk and return, diversification, asset allocation, investment policy statements and portfolio review. Questions test whether you can translate a client's goals and risk profile into a coherent allocation, and whether you understand costs, taxes and behavioural biases.
Core rules
- Risk and return are linked; higher expected return requires accepting more volatility and possible loss.
- Diversification reduces unsystematic risk; correlation determines how much. Low-correlation assets improve risk-adjusted return.
- Strategic allocation follows the IPS; tactical tilts are deliberate, limited and documented.
- Rebalance to policy weights using bands (for example ±5%) or a calendar; rebalancing enforces buy-low/sell-high discipline.
- Costs and taxes compound: a 1% fee or unnecessary turnover can consume a large share of long-term return.
- Time horizon and risk capacity constrain equity exposure more than a questionnaire score does.
Worked example
A 60/40 portfolio has expected returns of 7% for equities and 3% for bonds: 0.6 × 7% + 0.4 × 3% = 5.4%. With 2% inflation, the real expected return is about 3.3%. If fees and taxes take 1.2%, the real net return is about 2.1%. A goal requiring 3% real growth is therefore at risk; the planner should reduce costs, adjust the goal, or accept more risk only if capacity allows. This arithmetic, not past performance, should drive the recommendation.
Traps
Chasing recent winners; treating expected return as guaranteed; ignoring fees and taxes; over-concentrating in employer stock; rebalancing too often or never; using a risk score without capacity analysis.