Basics of Portfolio Planning and Construction
7 important questions on Basics of Portfolio Planning and Construction
Why is an investment policy statement (IPS) important?
An IPS starts by clearly defining the investor’s return objectives and risk tolerance, which must be set together. High returns always require accepting higher risk, so return expectations must match the investor’s ability and willingness to bear uncertainty.
How can risk and return objectives be stated in an Investment Policy Statement (IPS)?
- Absolute: limit losses based only on the portfolio itself (e.g. no loss, max loss, or a low probability of a specific loss).
- Relative: limit risk compared to a benchmark (e.g. not underperforming an index by more than a set amount).
Return objectives describe the desired level of return and must be consistent with the risk objective.
Key rule:
Risk and return objectives must be compatible—higher return goals require accepting higher risk.
Intuition:
Absolute risk = “How much can I lose?”
Relative risk = “How bad can I do versus the benchmark?”
What are the key investment constraints in an Investment Policy Statement (IPS)?
- Liquidity: need for quick access to cash → favors liquid assets
- Time horizon: longer horizon = more risk possible; shorter horizon = safer assets
- Tax concerns: focus on after-tax returns and account type
- Legal & regulatory: laws may restrict certain investments or allocations
- Unique circumstances: ethical, religious, or concentration preferences
Constraints define what you cannot do, even if returns look attractive.
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What is the difference between strategic and tactical asset allocation?
Tactical asset allocation involves temporary deviations from the strategic allocation to benefit from short-term market opportunities.
Intuition:
Strategic = the plan
Tactical = short-term adjustments to the plan
What is risk budgeting in portfolio management?
Each decision is given a risk allowance so total portfolio risk stays under control.
Intuition:
Risk budgeting treats risk like money—you decide how much you can spend and where.
What is the core–satellite approach in portfolio management?
The core provides stable, low-cost market exposure, while the satellite allows for security selection or tactical asset allocation where managers believe opportunities exist.
Explain the following ESG investing approaches: negative screening, positive screening, thematic investing, impact investing, engagement/active ownership, and ESG integration.
- Negative screening: excluding specific companies or industries based on ESG concerns.
- Positive screening: investing in companies with strong or improving ESG practices.
- Thematic investing: investing in sectors or companies linked to specific ESG themes or goals (e.g. renewable energy).
- Impact investing: investing to achieve both a financial return and a measurable positive ESG impact.
- Engagement / active ownership: using shareholder rights (voting, dialogue) to influence companies to improve ESG behavior.
- ESG integration: incorporating ESG factors systematically into asset allocation and security selection.
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