Investment Planning and Asset Allocation
Domain overview
Investment planning and asset allocation tests your ability to match a portfolio to objectives, risk tolerance, time horizon, and liquidity needs. Expect questions on diversification, correlation, strategic versus tactical allocation, rebalancing, and the difference between willingness and capacity to take risk.
Core principles
Risk and expected return are related; higher expected return generally requires accepting more volatility. Diversification reduces unsystematic risk but not market risk. Asset allocation is the primary driver of portfolio variability. Strategic allocation sets long-term targets; tactical allocation makes shorter-term deviations. Risk tolerance has an emotional component (willingness) and a financial component (capacity).
Rebalancing
Set target weights and a rebalancing rule, such as calendar-based or threshold-based. Rebalancing restores the intended risk level; it is not a forecast. Consider transaction costs, taxes, and the use of new contributions before selling.
Worked example
A client targets 60% equities and 40% bonds on a $100,000 portfolio. After a strong equity year, the portfolio is $70,000 equities and $30,000 bonds (70/30). The target is $60,000/$40,000. Rebalancing requires selling $10,000 of equities and buying $10,000 of bonds. If the policy has a 5-percentage-point band, the 70% equity weight breaches the 65% upper band and triggers action. The reasoning ties a rule to a trade rather than reacting to market headlines.
Traps that cost marks
- Treating a high risk tolerance as high risk capacity.
- Chasing recent performance.
- Ignoring fees, taxes, and liquidity.
- Rebalancing every small deviation without a policy.