CFP - Investment Planning (17% of the exam) - Section D.31

Asset allocation and portfolio diversification

Strategic versus tactical allocation, the efficient frontier, correlation's role in diversification, rebalancing methods, core-satellite construction and asset location across taxable and tax-advantaged accounts. Items give a client profile and ask for the allocation change that best fits.

Efficient frontierAsset location

Practice question for this objective

Free sampleInvestment Planninghard

Elena's investment policy statement sets a strategic allocation of 60 per cent equities and 40 per cent bonds, with a rebalancing band of 5 percentage points around each target and an explicit statement that no tactical deviation from the strategic weights is authorised. After a strong equity year her portfolio stands at 68 per cent equities and 32 per cent bonds, and her planner believes equities are now expensive. What action does the policy statement require?

ASell the equity overweight and buy bonds to restore the 60 and 40 targets, since the equity weighting has moved beyond the 5 percentage point band Correct
BLeave the allocation at 68 per cent equities and revisit the portfolio at the scheduled annual review, since a calendar approach avoids trading on short term price movement
CReduce equities to 50 per cent as a tactical underweight, since the planner's valuation view justifies moving below the strategic target while prices are high
DRaise the strategic equity target to 68 per cent so that the current holdings sit at policy, since the client has demonstrated a tolerance for the higher weighting

Apply a threshold rebalancing rule to a drifted portfolio and distinguish rebalancing to strategic weights from a tactical tilt. Threshold rebalancing triggers on the size of the drift, so an equity weighting 8 percentage points above a 60 per cent target has breached a 5 point band and must be traded back. The mechanic is what makes the discipline valuable: the asset class that has appreciated is sold and the one that has lagged is bought, so the rule enforces selling high and buying low without requiring any forecast. A tactical underweight is a different decision, because it moves the portfolio away from policy on the strength of a market view, and Elena's policy statement does not authorise it.

Why A is correct: The equity weighting has drifted 8 percentage points above target and so has breached the 5 point band, and a threshold rule requires a trade back to the strategic weights at that moment regardless of where the calendar stands.

Why B is wrong: A calendar approach is a legitimate rebalancing method, but Elena's policy statement adopts a threshold approach, and under a threshold rule the trigger is the size of the drift rather than the arrival of a review date.

Why C is wrong: This is a tactical asset allocation move, and it is expressly prohibited by a policy statement that authorises no deviation from the strategic weights, so acting on the valuation view would breach the document that governs the portfolio.

Why D is wrong: Resetting the target to match the drift confuses a market outcome with a change in the client's circumstances, because a strategic target is revised when goals, horizon or capacity for loss change rather than when prices move.

See more CFP practice questions, answers explained.

Exam traps in Investment Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

The curved frontier of risky assets remains the efficient set, because the risk free asset lies on that frontier at the point where standard deviation equals zero
Why it is wrong: The frontier is constructed from risky assets, so the risk free asset does not lie on it, and treating the vertical intercept as a frontier point is why this answer feels geometrically tidy while misdescribing what the frontier contains.
Bond fund in the taxable account, index fund in the Roth Individual Retirement Account, small capitalisation fund in the traditional Individual Retirement Account
Why it is wrong: This reverses the efficient placement, because it exposes ordinary interest income to Daniel's high marginal rate every year while spending the most valuable tax free space on the holding with the least growth potential of the three positions.
Add roughly ten further regional bank shares, since the bulk of unsystematic risk disappears once a portfolio holds about 25 individual securities rather than 15
Why it is wrong: The familiar figure of 20 to 30 securities assumes holdings drawn from different industries, so adding more shares from the same sector raises the count while leaving the shared industry exposure that is doing the damage untouched.

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