Learning Module 4
Basics of Portfolio Planning and Construction
Key Outcomes Summary & Practice Problems
What you must be able to do
Curriculum Year: 2026
Describe the reasons for a written investment policy statement (IPS).
Describe the major components of an IPS.
Describe risk and return objectives and how they may be developed for a client.
Explain the difference between the willingness and the ability (capacity) to take risk in analyzing an investor's financial risk tolerance.
Describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets.
Explain the specification of asset classes in relation to asset allocation.
Describe the principles of portfolio construction and the role of asset allocation in relation to the IPS.
Describe how environmental, social, and governance (ESG) considerations may be integrated into portfolio planning and construction.
1 · The Investment Policy Statement (IPS)
Definition — A written document that communicates a plan for achieving investment success. It is the starting point of the portfolio management process.
Purpose — Without a full understanding of the client's situation and requirements, successful results are unlikely. The IPS captures the client's investment objectives and constraints.
Major Components — Introduction, Statement of Purpose, Statement of Duties and Responsibilities, Procedures, Investment Objectives, Investment Constraints, Investment Guidelines, Evaluation and Review, Appendices (Strategic Asset Allocation, Rebalancing Policy).
Review — The IPS should be reviewed regularly (e.g., every three years) and when material changes occur in the client's circumstances.
2 · Risk and Return Objectives
Risk Objectives — Specifications for portfolio risk that reflect the client's risk tolerance. Can be absolute (e.g., not lose more than 4% of capital) or relative (e.g., tracking risk relative to a benchmark).
Risk Tolerance — A function of ability to bear risk (objective factors: time horizon, income, wealth vs. liabilities) and willingness to take risk (subjective factors: psychology, personality, risk attitude).
Conflict Resolution — When ability and willingness conflict, the prudent approach is to assess risk tolerance consistent with the lower of the two factors.
Return Objectives — Can be absolute (specific percentage return) or relative (benchmark-relative, e.g., outperform S&P 500 by 1%).
Factor | Description |
|---|---|
High Ability / High Willingness | Above-average risk tolerance |
Low Ability / Low Willingness | Below-average risk tolerance |
High Ability / Low Willingness | Resolution needed (counsel client) |
Low Ability / High Willingness | Assess as below-average risk tolerance |
3 · IPS Constraints
Liquidity Requirements — Need to withdraw funds from the portfolio. Assets with low risk and high liquidity should be allocated to cover these needs.
Time Horizon — The period over which the investor is investing. Longer horizons allow for more risky/illiquid investments.
Tax Concerns — Taxable investors may prefer capital gains over income; tax-exempt investors (e.g., pension funds) are indifferent to the form of returns.
Legal and Regulatory Factors — Restrictions on portfolio composition (e.g., pension fund investment limits, insider trading restrictions).
Unique Circumstances & ESG — Personal objections, ethical preferences, human capital considerations, and ESG integration approaches.
4 · ESG Considerations
ESG Investment Approaches — Six generic approaches:
Excluding companies or sectors based on business activities or ESG concerns.
Including sectors or companies based on specific ESG criteria.
Systematic consideration of material ESG factors in investment decisions.
Investing in themes or assets related to ESG factors.
Using shareholder power to influence corporate behavior.
Investments made with the intention to generate positive social/environmental impact.
5 · Portfolio Construction & Asset Allocation
Strategic Asset Allocation (SAA) — The set of exposures to IPS-permissible asset classes that is expected to achieve the client's long-term objectives.
Asset Classes — Categories of assets with similar characteristics and risk-return relationships (e.g., cash, equities, bonds, real estate, alternatives).
Capital Market Expectations — Expectations concerning the risk and return prospects of asset classes (expected returns, standard deviations, correlations).
Tactical Asset Allocation — Deliberate deviations from policy exposures with the intent to add value based on near-term forecasts.
Risk Budgeting — The process of deciding on the amount of risk to assume and subdividing that risk over sources of return (SAA, tactical, security selection).
Rebalancing Policy — The set of rules that guide restoring the portfolio's original exposures to systematic risk factors.
Up = E(Rp) − λσp²
λ = risk aversion coefficient. The optimal portfolio maximizes utility.