Investment Planning: Risk, Return, Allocation, and Measurement
What this domain tests
Investment Planning tests risk-return trade-offs, asset allocation, diversification, portfolio measurement, and tax-aware investing. Expect calculations of portfolio return, Sharpe ratio, duration effects, and after-tax returns, plus conceptual items on market efficiency and behavioral bias.
Core rules and concepts
- Expected portfolio return is the weighted average of asset expected returns. Portfolio standard deviation is not a simple weighted average; it depends on covariances. Lower correlation reduces portfolio risk.
- Diversification reduces unsystematic risk, not systematic market risk. CAPM prices systematic risk with beta.
- Sharpe ratio = (portfolio return − risk-free rate) / standard deviation; higher is better for the same risk.
- Bond price sensitivity rises with duration and with the size of the rate change; duration approximates the percentage price change for a 1% rate move.
- Rebalance to targets using bands or calendar rules; consider taxes and transaction costs.
Worked example
A portfolio is 60% equity with expected return 8% and 40% bonds with expected return 3%. Expected return = 0.60 × 8% + 0.40 × 3% = 4.8% + 1.2% = 6.0%. If the portfolio fee is 0.50%, the net expected return is about 5.5% before taxes. Reasoning: weights must sum to 100%; fees reduce return directly; taxes would reduce it further, so compare after-tax returns when the question gives tax rates.
Traps that cost marks
- Comparing returns without comparing risk.
- Assuming low correlation means no risk; correlations can rise in crises.
- Using past performance as a forecast.
- Ignoring expense ratios, turnover, and taxes.
- Misreading duration as maturity; a 10-year bond with 7-year duration falls about 7% for a 1% rate rise.