Constructing Investment Portfolios Flashcards

A 25-year-old investor with a high risk tolerance and a 40-year time horizon for retirement is constructing their first portfolio. Which of the following asset allocations would be MOST suitable for their primary long-term goal?

Answer: 90% Equity, 10% Fixed Income

A young investor with a long time horizon (40 years) and a high tolerance for risk can afford to take on more market volatility in exchange for potentially higher long-term returns. An asset mix heavily weighted towards equities is appropriate for a growth-oriented objective.

An investor's portfolio has a target asset mix of 60% equities and 40% bonds. Due to strong market performance, the equity portion has grown to represent 75% of the portfolio's value. Which of the following actions describes the process of rebalancing?

Answer: Selling a portion of the equity holdings and using the proceeds to buy bonds.

Rebalancing is the process of realigning the weightings of a portfolio's assets. This involves selling asset classes that have grown beyond their target allocation and buying those that are underweight to restore the portfolio to its original strategic asset mix.

Which of the following risks can be significantly mitigated through proper diversification of a portfolio across various asset classes, industries, and geographic regions?

Answer: Unsystematic risk

Unsystematic risk, also known as diversifiable or specific risk, is the risk inherent to a specific company or industry. It can be significantly reduced by combining a variety of assets in a portfolio. Systematic risk (e.g., interest rate risk, inflation risk) affects the entire market and cannot be eliminated through diversification.

Which of the following statements best describes strategic asset allocation?

Answer: It is the process of establishing a long-term, target asset mix based on a client's objectives and risk tolerance.

Strategic asset allocation is the foundational, long-term plan for a portfolio. It involves setting target allocations for various asset classes based on the investor's specific goals, risk tolerance, and time horizon, and it is maintained through periodic rebalancing.

What is the primary objective of adding assets with low or negative correlation to each other within an investment portfolio?

Answer: To reduce the portfolio's overall volatility.

The core principle of diversification is that by combining assets that do not move in the same direction at the same time (i.e., have low or negative correlation), the overall ups and downs of the portfolio can be smoothed out. This reduces the portfolio's standard deviation, or volatility.

A retired couple, both aged 70, require their portfolio to generate consistent monthly cash flow to cover their living expenses. They are highly averse to volatility and wish to preserve their capital. Which primary investment objective best describes their needs?

Answer: Income and Capital Preservation

The clients' need for regular cash flow, low risk tolerance, and desire to protect their initial investment align directly with the investment objectives of income and capital preservation. Growth and speculation objectives would involve taking on significantly more risk, which is unsuitable for their stated needs.