Savings, Investments and Asset Allocation
This domain covers the risk–return relationship, asset classes, diversification, and asset allocation. Candidates must know the main asset classes - cash, fixed interest (bonds), equities, property, and alternatives - and their characteristics: equities offer growth with volatility; bonds offer income with interest-rate and credit risk; cash offers liquidity with inflation risk.
Key concepts: systematic vs unsystematic risk (diversification reduces the latter, not the former); correlation (low correlation improves portfolio efficiency); time horizon (longer horizons support higher equity weight); and rebalancing to maintain target weights. Collective investment schemes (OEICs, unit trusts, investment trusts) pool money; note the structural difference - investment trusts are closed-ended companies, OEICs are open-ended.
Traps: assuming diversification eliminates all risk; confusing active and passive management costs; ignoring charges' compounding drag; and treating past performance as predictive. Also watch for questions on risk-profiling tools - they inform but do not replace advice.
Worked example: A client with a 20-year horizon and medium risk tolerance holds 80% cash and 20% equities. Over 20 years, cash may struggle to beat inflation, creating a shortfall risk. A more suitable allocation might be 60–70% growth assets with the remainder in bonds and cash for stability. The point is to align allocation with horizon and capacity for loss, not with recent market performance.
Rule of thumb: diversify across assets, not just within them; match risk to horizon.