You are handed three client files: a 28-year-old engineer with $80,000 saved, a state pension fund covering 200,000 retirees, and a sovereign wealth fund with a 50-year horizon. The exam wants you to know why one investment policy cannot serve all three.
A portfolio is a collection of investments held as a unit. Analysts describe the portfolio approach as one that evaluates risk and return at the aggregate level, not security by security. The core insight comes from Markowitz: combining assets whose returns are not perfectly correlated reduces total portfolio variance without lowering expected return. You get the same return for less risk, or more return for the same risk.
KEY: Diversification works because correlations between asset returns are below 1.0. The portfolio's standard deviation is lower than the weighted average of individual standard deviations whenever .
Modern Portfolio Theory (MPT) formalizes this. Rational investors are risk-averse and select portfolios that maximize expected return for a given level of risk. The set of optimal portfolios forms the efficient frontier.
Common mistakes
- Confusing who bears investment risk in pension plans. Defined benefit = sponsor bears the risk (the benefit is defined, the contribution adjusts). Defined contribution = employee bears the risk (the contribution is defined, the benefit varies with returns). Trap: "DB participants bear investment risk because they receive the pension."
- Treating diversification as a function of number of holdings. Risk reduction comes from low correlations, not from holding many securities. A portfolio of 50 correlated US bank stocks is barely diversified. Trap: "Holding 100 securities ensures diversification."
- Writing the IPS after choosing assets. The IPS comes first. Capital market expectations and asset allocation follow. The IPS shapes the allocation, not the reverse. Trap: drafting the IPS to justify a pre-decided portfolio.
Bottom line
- Portfolio approach beats individual security selection because low-correlation diversification reduces risk without sacrificing expected return; adding correlated holdings does not diversify.
- Six-step process: planning, execution, feedback. Write the IPS first, monitor and rebalance last.
- IPS has seven elements: the Return and Risk objectives, plus constraints Time horizon, Taxes, Liquidity, Legal, and Unique circumstances.
- Defined benefit plan: sponsor bears investment risk. Defined contribution plan: employee bears investment risk.
Exam shortcut
When asked who bears investment risk: defined benefit = sponsor; defined contribution = employee. The word that is "defined" tells you what does NOT vary, the other side absorbs the variation. For mutual fund classification: open-end transacts with the fund at NAV; closed-end trades on an exchange at market price; ETF trades on an exchange but stays near NAV through arbitrage.
The full lesson (about 3,368 words, 22 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- portfolio management overview
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