Basics of Portfolio Planning and Construction

A portfolio is only as good as the plan behind it. This module covers how a written investment policy statement captures a client's objectives and constraints, how to set risk and return objectives and calculate a required return, how to reconcile a client's willingness and ability to take risk, and how constraints shape asset choices. It then shows how asset classes are defined, how a strategic asset allocation and rebalancing policy turn the plan into a portfolio, and how ESG considerations can be built in.

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What you will learn

1. Explain why a written investment policy statement is needed and describe its main components.

The IPS records the client's objectives, constraints and the rules for managing the portfolio.
Benefits: understanding the client, discipline, continuity, and a basis for evaluation.
Objectives = return and risk; constraints = liquidity, horizon, taxes, legal/regulatory, unique circumstances.
Investment guidelines specify permitted assets, leverage and derivatives limits and similar rules.
Review the IPS regularly and whenever the client's circumstances change.

2. Describe risk and return objectives and calculate a client's required return.

Absolute risk objectives: standard deviation, drawdown or loss limits; relative: tracking error versus a benchmark.
Return objectives can be absolute or relative; distinguish required from desired return.
Risk and return objectives must be consistent with each other and with the client's risk tolerance.
Required return (multiplicative) = (1 + spending)(1 + inflation)(1 + costs) - 1; additive is an approximation.
State whether objectives are nominal or real, before or after taxes and costs.

3. Explain the difference between a client's willingness and ability to take risk and how the two are combined into an overall risk tolerance.

Ability to take risk is objective: horizon, wealth relative to needs, income stability, liabilities.
Willingness to take risk is subjective: attitudes, personality, past behavior, questionnaire results.
If willingness exceeds ability, ability governs.
If ability exceeds willingness, generally follow willingness but educate the client.
Overall risk tolerance is usually the lower of the two.

4. Describe the investment constraints of liquidity, time horizon, taxes, legal and regulatory factors, and unique circumstances, and their implications for the choice of assets.

Liquidity: planned and unplanned cash needs limit illiquid holdings.
Time horizon: longer horizons raise the ability to take risk; horizons can have several stages.
Taxes: compare alternatives after tax; after-tax return = pre-tax return x (1 - tax rate).
Legal and regulatory constraints are imposed externally.
Unique circumstances include self-imposed ethical exclusions and special personal situations.

5. Explain how asset classes are specified for asset allocation and describe the principles of portfolio construction, including strategic asset allocation, tactical deviations, rebalancing and the core-satellite approach.

Asset classes should be homogeneous, mutually exclusive, diversifying, comprehensive and have capacity.
Strategic asset allocation = long-term target weights combining the IPS and capital market expectations.
Active risk comes from tactical allocation and security selection, controlled by a risk budget.
Rebalancing corridors bring weights back towards targets when they drift outside set ranges.
Core-satellite: passive core plus smaller active satellites.

6. Describe how environmental, social and governance considerations can be integrated into portfolio planning and construction.

Record ESG preferences in the IPS, with the approach, benchmark and accepted tracking error.
Negative screening excludes; positive or best-in-class screening favours ESG leaders within peer groups.
ESG integration adds material ESG factors to fundamental analysis.
Thematic and impact investing target specific themes or measurable impact.
Active ownership uses engagement and proxy voting to change company behaviour.

Module at a glance

The IPS records objectives, constraints, responsibilities, guidelines and review procedures; review it regularly.
Risk objectives can be absolute (volatility, loss limits) or relative (tracking error).
Required return = (1 + spending)(1 + inflation)(1 + costs) - 1.
Overall risk tolerance is the lower of willingness and ability; ability governs when it is lower.
Constraints: liquidity, time horizon, taxes, legal/regulatory, unique circumstances (self-imposed exclusions).
Strategic asset allocation sets long-term targets; corridors trigger rebalancing.
ESG approaches: exclusion, best-in-class, integration, thematic, impact and active ownership.

This free module has 6 lessons, 20 practice questions with full explanations.

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