Portfolio development and analysis

Writing and applying an investment policy statement, matching risk tolerance and capacity to a portfolio, benchmark selection, attribution and performance evaluation, and monitoring for drift. Items test which IPS element or analysis a described client situation calls for.

Investment policy statement

Practice question for this objective

Free sampleInvestment Planninghard

Priya, aged 41, earns 210,000 dollars a year and holds a 1,400,000 dollar taxable portfolio. She has told her planner she wants a 9 percent average annual return. She also needs 200,000 dollars in cash in 18 months for a deposit on a second home, and 480,000 dollars of the portfolio sits in a single employer share position with a cost basis of 60,000 dollars that she is unwilling to sell in one transaction. When the planner drafts the investment policy statement, how should these three facts be treated?

ARecord the 9 percent figure as the return objective and add the deposit and the share position as background notes outside the policy statement, since neither changes the long-run expected return of the portfolio.
BLiquidate the concentrated share position in full before the policy statement is signed, hold the 200,000 dollars in cash, and then set the return objective on the resulting diversified portfolio at 9 percent a year.
CSet the return objective at the level the portfolio can be expected to earn once the 18-month liquidity reserve and a staged disposal of the low-basis shares are recorded as constraints, then state the objective in those terms. Correct
DEnter the deposit and the concentrated position under the return and risk objectives of the policy statement, because both of them determine how much return Priya needs and how much volatility she can tolerate.

Constraints in an investment policy statement bound the achievable return objective, so they are identified and recorded before the objective is set. An investment policy statement pairs objectives with constraints, and the constraints come first in the analysis. An 18-month liquidity call must be funded from short-dated assets that earn less than the long-horizon balance, and a 480,000 dollar position with a 60,000 dollar basis can be reduced only in stages without a large tax cost. Both facts shrink the risk the remaining portfolio can take and therefore shrink the return it can be expected to produce, so a 9 percent objective set in advance of them is an aspiration rather than a policy. Writing the constraints first and deriving the objective from what remains produces a statement a manager can actually be measured against.

Why A is wrong: Tempting because the long-run expected return of the remaining assets really is unaffected by a note. It is wrong because a liquidity need and a concentrated low-basis holding are formal constraints, and a policy statement that leaves them outside the document gives the manager no boundary to invest within.

Why B is wrong: Tempting because full diversification does remove the single-stock risk. It is wrong on two counts: it triggers gain on 420,000 dollars in one tax year, and it overrides a stated client preference by acting before the policy statement that is meant to govern the action exists.

Why C is correct: Correct because constraints bound the feasible objective. Carving out a short-horizon reserve for the deposit and accepting a staged, tax-aware reduction of the concentrated position both lower the return the balance of the portfolio can be asked to produce, so the objective is written after the constraints, not before them.

Why D is wrong: Tempting because both facts genuinely influence the objectives. It is wrong because it confuses the two sections: liquidity and tax are constraints that limit the opportunity set, while the objectives state the required return and the acceptable risk that the constrained portfolio must then deliver.

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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 portfolio beat the benchmark by 2.4 percentage points, of which 1.2 points came from allocation and 1.2 points came from selection, since the manager both overweighted equities and held them through a rising year.
Why it is wrong: Tempting because it doubles a correct allocation figure by counting the same overweight twice. It is wrong because the manager's securities matched the benchmark component returns exactly, so no part of the excess can be attributed to selection, and the total excess is 1.2 points rather than 2.4.
The standard deviation of the new share on its own, because the total variability of the share is what it will contribute to the variability of the whole portfolio.
Why it is wrong: Tempting because standard deviation is the right answer for a concentrated portfolio. It is wrong here because most of the new share's own variability is company specific and will be absorbed by the 45 existing holdings, so its standalone figure overstates what it adds.
Adopt the 75 percent equity allocation, because ability to take risk rests on measurable facts about horizon, income and wealth, while willingness rests on a self-reported score that a questionnaire is known to measure imprecisely.
Why it is wrong: Tempting because ability really is the more objective of the two inputs. It is wrong because Marcus has a behavioural record, not merely a score: he has twice sold after a fall, so an allocation he abandons in a drawdown delivers worse realised results than a lower one he keeps.

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