Portfolio Theory

Portfolio Theory: Client Investment Recommendations Why this matters on the exam: Portfolio theory questions appear consistently in Section III (30% of the exam) and require you to apply concepts like CAPM, diversification, and risk-adjusted performance measures to real client scenarios — not just define terms. Expect 5–8 questions that blend math, interpretation, and practical application. --- ## The Big Picture: Why Portfolio Theory Exists The core insight of portfolio theory is simple: *how you combine investments matters as much as which investments you pick.* A rational investor wants the highest possible return for a given level of risk. Portfolio theory gives advisers the mathematical framework to build that portfolio — and the exam tests whether you can apply it. --- ## Modern Portfolio Theory (MPT) Modern Portfolio Theory (MPT), developed by Harry Markowitz, holds that investors should not evaluate securities in isolation but rather by how each security contributes to the overall portfolio's risk and return. The key variable is correlation — a statistical measure (ranging from −1.0 to +1.0) of how two assets move relative to each other. | Correlation | Meaning | Diversification Benefit | |---|---|---| | +1.0 | Perfect positive — move in lockstep | None | | 0 | No relationship | Moderate | | −1.0 | Perfect negative — move opposite | Maximum (theoretical) | Diversification reduces unsystematic risk (also called *company-specific* or *idiosyncratic* risk) — the risk unique to a single issuer. It does not eliminate systematic risk (also called *market risk* or *non-diversifiable risk*), which affects all securities. > Worked Example: A client holds only airline stocks. She adds hotel stocks. If both industries decline during recessions together (positive correlation), she gains…