Reading 64: basics of portfolio planning and construction

Question 1

The investment policy statement is most accurately considered:
the starting point of the portfolio management process.
the key intermediate step in the portfolio management process.
the end product of the portfolio management process.

Answer 1

An investment policy statement is considered to be the starting point of the portfolio management process. The IPS is a plan for achieving investment success. (LOS 64.a)

Question 2

The component of an investment policy statement that defines the investment objectives is most likely to include information about:
the investor’s risk tolerance.
unique needs and preferences of the investor.
permitted asset types and use of leverage in the investment account.

Answer 2

Investment objectives are defined based on both the investor’s return requirements and risk tolerance. Investment constraints include the investor’s time horizon, liquidity needs, tax considerations, legal and regulatory requirements, and unique needs and preferences. Policies regarding permitted asset types and the amount of leverage to use are best characterized as investment guidelines. (LOS 64.b)

Question 3

When an investment advisor is developing return and risk objectives for a client:
return objectives should be absolute and risk objectives should be relative.
risk objectives should be absolute and return objectives should be relative.
both return and risk objectives may be stated in absolute or relative terms.

Answer 3

Both risk and return objectives can be defined either in absolute terms or relative to some benchmark. (LOS 64.c)

Question 4

A client exhibits an above-average willingness to take risk but a below-average ability to take risk. When assigning an overall risk tolerance, the investment adviser is most likely to assess the client’s overall risk tolerance as:
above average.
average.
below average.

Answer 4

When assigning an overall risk tolerance, the prudent approach is to use the lower of ability to take risk and willingness to take risk. (LOS 64.d)

Question 5

Which of the following is least likely an example of a portfolio constraint?
Higher tax rate on dividend income than on capital gains.
Significant spending requirements in the near future.
Minimum total return requirement of 8%.

Answer 5

Return objectives are part of a policy statement’s objectives, not constraints. (LOS 64.e)

Question 6

For asset allocation purposes, asset classes should be specified such that correlations of returns are relatively:
low within each asset class and low among asset classes.
high within each asset class and low among asset classes.
low within each asset class and high among asset classes.

Answer 6

Asset classes should be defined such that correlations of returns within the asset class are relatively high (because assets within a class should perform alike over time), while correlations of returns among asset classes are relatively low (to benefit from diversification). (LOS 64.f)

Question 7

In determining the appropriate asset allocation for a client’s investment account, the manager should:
consider only the investor’s risk tolerance.
incorporate forecasts of future economic conditions.
consider the investor’s risk tolerance and future needs, but not forecasts of market conditions.

Answer 7

An adviser’s forecasts of the expected returns and expected volatilities (risk) of different asset classes are an important part of determining an appropriate asset allocation. (LOS 64.g)