Investment Analysis, Risk and Portfolio Construction
This domain tests whether you can translate client objectives into an allocation and defend it in numbers: expected return, dispersion, correlation, and the cost of being wrong.
Core rules
- Total risk = systematic (market) + unsystematic (specific). Diversification removes the unsystematic part; beta measures the systematic part.
- CAPM: expected return = risk-free rate + beta × equity risk premium. A stock with beta 0.8 is expected to move 80% as far as the market.
- Sharpe ratio = (portfolio return − risk-free rate) ÷ standard deviation, pricing excess return per unit of total risk. Treynor substitutes beta for standard deviation.
- Asset allocation drives most of the variability in portfolio returns. Rebalancing restores target weights and mechanically sells recent winners.
- Risk profiling informs the allocation but never replaces the capacity-for-loss assessment.
Worked example
Portfolio A returns 8.0% with a standard deviation of 12.0%; Portfolio B returns 6.5% with a standard deviation of 8.0%. The risk-free rate is 2.0%. Which is better risk-adjusted? Reasoning: Sharpe A = (8.0 − 2.0) ÷ 12.0 = 0.50. Sharpe B = (6.5 − 2.0) ÷ 8.0 = 0.5625. B wins. The higher headline return in A was bought with disproportionately more volatility - and note that Sharpe assumes roughly normal returns, so it understates tail risk in both cases.
Traps that cost marks
- Quoting an arithmetic mean as the expected compound return; geometric returns sit below arithmetic ones.
- Claiming diversification eliminates market risk - it removes only the specific component.
- Comparing Sharpe ratios across different periods or asset classes without adjustment.
- Confusing a fund's risk rating with the client's own capacity for loss.