Investment Planning
What the exam tests
Investment Planning tests portfolio construction, risk measurement, asset allocation, performance evaluation and behavioural pitfalls. Questions often require a calculation plus interpretation.
Core rules
- Portfolio expected return is the weighted average of asset returns.
- Portfolio risk is not the weighted average of risks when correlations are below 1; diversification reduces volatility.
- Sharpe ratio = (portfolio return − risk-free rate) / standard deviation. It measures excess return per unit of total risk; beta measures systematic risk instead.
- The efficient frontier shows portfolios offering the highest expected return for each level of risk.
- Rebalancing controls drift; costs, taxes and trading frequency determine whether it adds value.
- Match the wrapper to the tax position: pension, ISA or general account.
Worked example
A portfolio is 60% equities (expected return 7%, SD 15%) and 40% bonds (3%, SD 5%), correlation 0.2. Expected return = 0.6×7 + 0.4×3 = 5.4%. Variance = 0.36×225 + 0.16×25 + 2×0.6×0.4×0.2×15×5 = 81 + 4 + 7.2 = 92.2, so SD = 9.6%. The weighted-average SD would be 0.6×15 + 0.4×5 = 11%. The 1.4 percentage-point reduction is the diversification benefit; it disappears if correlation rises to 1.
Traps
- Treating standard deviation and beta as interchangeable.
- Assuming a low correlation removes risk entirely.
- Comparing returns without adjusting for risk or fees.
- Using a Sharpe ratio carelessly when excess returns are negative.
- Ignoring currency and liquidity risk.