Investment Planning and Asset Allocation
Investment Planning and Asset Allocation
This domain tests the investment policy statement, risk tolerance and capacity, strategic asset allocation, diversification, performance measurement, and rebalancing.
Core rules and concepts
- Investment policy statement: objectives, return requirement, risk tolerance, time horizon, liquidity, taxes, legal constraints, and unique circumstances.
- Strategic allocation follows the IPS; tactical tilts are short-term and must be justified.
- Diversification reduces unsystematic risk; correlation determines the benefit.
- Risk tolerance is emotional willingness; risk capacity is financial ability to bear loss.
- Sharpe ratio = (portfolio return − risk-free rate) / standard deviation.
- Tax-efficient placement: hold tax-inefficient assets in tax-deferred accounts when appropriate.
- Rebalance to policy weights using bands or calendar rules.
Worked example
A 60/40 portfolio has expected returns of 8% equities and 3% bonds. Expected return = 0.60×8% + 0.40×3% = 6.0%. If the portfolio actually returns 7.2% with a standard deviation of 10% and the risk-free rate is 2%, Sharpe ratio = (7.2% − 2%)/10% = 0.52. After a strong equity year, the mix may drift to 70/30; rebalancing sells equities and buys bonds, restoring the IPS risk level rather than chasing performance.
Traps
- Treating risk tolerance and risk capacity as the same.
- Chasing recent performance or ignoring fees.
- Failing to rebalance after drift.
- Using an allocation that ignores the client's tax bracket and liquidity needs.