RIA Portfolio Management 2 — Questions and Answers

Question 1: Asset allocation primarily aims to:

Maximize short-term returns
Minimize taxes on gains
Balance risk and return across different asset classes (Correct answer)
Concentrate in top-performing sectors

Correct answer: Balance risk and return across different asset classes

Asset allocation distributes investments across asset classes to optimize the risk-return tradeoff for a client's goals.

Strategic asset allocation establishes target percentages for each asset class (stocks, bonds, cash, alternatives) based on client objectives, time horizon, and risk tolerance. It is the most important determinant of long-term portfolio returns and risk, accounting for over 90% of portfolio performance variance according to academic research.

Question 2: Rebalancing a portfolio involves:

Selling all underperforming assets
Returning allocations to target percentages (Correct answer)
Switching to a more aggressive strategy
Eliminating international exposure

Correct answer: Returning allocations to target percentages

Rebalancing restores the portfolio to its original target allocation by selling assets that have grown beyond targets and buying those that have fallen below.

Market movements cause asset class weights to drift from targets. Rebalancing sells appreciated assets (taking profits) and buys depreciated assets (buying low), maintaining the intended risk level. Advisers must consider transaction costs, tax implications, and timing when rebalancing. Common approaches include calendar-based, threshold-based, or hybrid rebalancing.

Question 3: The primary purpose of a benchmark in portfolio management is to:

Set maximum investment amounts
Provide a standard against which portfolio performance is measured (Correct answer)
Determine client fees
Set asset allocation targets only

Correct answer: Provide a standard against which portfolio performance is measured

A benchmark provides a reference point to evaluate whether a portfolio manager is adding value relative to the market.

Benchmarks (like the S&P 500 for large-cap US equity) allow advisers and clients to evaluate whether active management decisions generate returns above what could be earned passively. The appropriate benchmark should match the portfolio's investment style and asset class. Performance attribution analysis compares actual performance to the benchmark.

Question 4: Dollar-cost averaging is a strategy that involves:

Investing a lump sum at market highs
Investing fixed amounts at regular intervals regardless of price (Correct answer)
Trading based on dollar volume only
Selling when prices fall to fixed levels

Correct answer: Investing fixed amounts at regular intervals regardless of price

Dollar-cost averaging invests a fixed dollar amount at regular intervals, buying more shares when prices are low and fewer when high.

DCA reduces the impact of market volatility by spreading purchases over time. When prices fall, the fixed amount buys more shares; when prices rise, it buys fewer. Over time, this typically results in a lower average cost per share than lump-sum investing at random times. It's particularly useful for investors who are emotionally affected by market volatility.

Question 5: Which portfolio theory concept suggests that investors should only take on additional risk if compensated with additional return?

Efficient Market Hypothesis
Risk-return tradeoff (Correct answer)
Random walk theory
Capital structure theory

Correct answer: Risk-return tradeoff

The risk-return tradeoff principle states that higher potential returns require accepting higher risk.

The risk-return tradeoff is fundamental to investment theory: rational investors require higher expected returns as compensation for bearing greater risk. This principle underlies portfolio construction, security pricing, and performance evaluation. Advisers use it when explaining why conservative portfolios earn less than aggressive ones over time.

Question 6: A tactical asset allocation strategy differs from strategic asset allocation by:

Setting permanent allocations never to be changed
Eliminating all equity exposure
Making short-term adjustments based on market conditions (Correct answer)
Focusing only on fixed income

Correct answer: Making short-term adjustments based on market conditions

Tactical asset allocation makes temporary deviations from strategic targets to exploit short-term market opportunities.

While strategic asset allocation sets long-term targets based on client objectives, tactical allocation allows temporary deviations to take advantage of market conditions (overweighting equities when stocks appear cheap, for example). Tactical allocation introduces active management risk but may improve returns if done skillfully. Eventually, the portfolio returns to strategic targets.

RIA Portfolio Management 2

Asset allocation primarily aims to: