Techniques
Portfolio management strategies set the overall allocation. Techniques are the specific tools advisers use to execute those strategies: reducing risk, generating income, amplifying returns, or hedging positions.
Diversification
Diversification spreads investments across different asset classes, sectors, geographies, and securities to reduce risk. It reduces unsystematic (diversifiable) risk - the risk specific to individual companies or industries. It does NOT eliminate systematic (market) risk - risk affecting the entire market.
How Correlation Drives Diversification
Effectiveness depends on correlation between holdings:
- Correlation of +1.0 = move in perfect lockstep (no diversification benefit)
- Correlation of 0 = no relationship (moderate benefit)
- Correlation of -1.0 = move in opposite directions (maximum benefit)
What to Diversify Across
- Asset classes to diversify across: domestic equity, international equity, fixed income, real estate, commodities, cash
- Over-diversification (diworsification) can occur when adding more securities no longer reduces risk but increases costs and complexity
Think of it this way: Diversification makes sure the eggs within each basket come from different farms. The less connected those farms are, the less likely they all fail at once.
Exam Tip: Gotchas
- Even a perfectly diversified portfolio retains all systematic risk. A question asking "what risk remains after full diversification?" is asking about market/systematic risk.
- For maximum diversification benefit, combine assets with low or negative correlation.
Sector Rotation
Sector rotation shifts portfolio allocation among economic sectors based on the business cycle. It is an active management technique that requires forecasting which sectors will outperform in each economic phase.
Business Cycle and Sector Leadership
| Business Cycle Phase | Favored Sectors | Rationale |
|---|---|---|
| Early expansion | Technology, consumer discretionary, industrials | Rising confidence, increased spending |
| Mid expansion | Materials, energy, industrials | Production ramps up, commodity demand rises |
| Late expansion | Energy, materials, healthcare | Inflation hedge, defensive positioning |
| Contraction/recession | Utilities, healthcare, consumer staples | Defensive sectors, essential goods/services |
- Requires successful market timing, which is difficult to execute consistently
Exam Tip: Gotchas
- Rotate INTO defensive sectors during contraction and INTO cyclical sectors during early expansion. This is a common reversal trap on the exam.
Dollar-Cost Averaging
Dollar-cost averaging (DCA) invests a fixed dollar amount at regular intervals regardless of the current share price. The investor does NOT buy a fixed number of shares; the fixed element is the dollar amount.
How DCA Works
- When prices are low, the fixed dollar amount buys more shares
- When prices are high, the fixed dollar amount buys fewer shares
- The result: the average cost per share is always lower than the average price per share in a fluctuating market
DCA Example
An investor commits $600 per month for four months:
| Month | Price/Share | Shares Purchased |
|---|---|---|
| 1 | $20 | 30.00 |
| 2 | $24 | 25.00 |
| 3 | $30 | 20.00 |
| 4 | $40 | 15.00 |
| Total | 90 shares |
- Total invested: $2,400
- Average price per share: ($20 + $24 + $30 + $40) / 4 = $28.50
- Average cost per share: $2,400 / 90 shares = $26.67
- The average cost ($26.67) is lower than the average price ($28.50) because DCA automatically buys more shares at lower prices
DCA Limitations
- Does NOT guarantee a profit or protect against loss in a declining market
- Most effective in volatile, fluctuating markets
- Common implementation: automatic payroll deductions into 401(k) plans
- Lump-sum investing typically outperforms DCA over long periods (because markets trend upward), but DCA reduces timing risk
Exam Tip: Gotchas
- DCA uses a fixed dollar amount, NOT a fixed number of shares. If a question describes buying 100 shares every month, that is NOT dollar-cost averaging.
- Average cost per share is ALWAYS lower than average price per share in a fluctuating market. This is a math relationship, not a guarantee of profit.
Options Strategies
Options strategies are used for hedging (risk reduction), not speculation, in an advisory context.
Core Options Strategies
- Protective put - buying a put option on a stock you own to limit downside risk
- Acts as insurance - limits losses below the strike price minus premium paid
- Preserves unlimited upside potential (minus premium cost)
- Appropriate for investors who want downside protection but want to keep the stock
- Covered call - selling (writing) a call option on a stock you own
- Generates premium income that partially offsets potential losses
- Caps upside at the strike price (shares may be called away if price rises above strike)
- Appropriate for income-oriented investors or when expecting flat/modest price movement
- Collar - simultaneously buying a protective put and selling a covered call
- Put premium partially or fully offset by call premium received
- Creates a range of possible outcomes (limited downside and limited upside)
Think of it this way: Buying a protective put is like buying homeowner's insurance. You pay a premium for the right to be "made whole" if something bad happens. Selling a covered call is like renting out your spare room: extra income, but you give up some control.
Exam Tip: Gotchas
- A protective put limits losses. A covered call generates income but caps gains. The exam may present a scenario asking which strategy protects against downside: the answer is the protective put, NOT the covered call.
Leveraging
Leverage uses borrowed funds (margin) to increase the size of an investment position. It amplifies both gains AND losses - a double-edged sword.
Margin Requirements
- Margin account required; investor borrows from the broker-dealer using securities as collateral
- Regulation T sets initial margin requirement at 50% (investor must deposit at least half the purchase price)
- Maintenance margin is the minimum equity that must be maintained (typically 25% per FINRA, firms may require more)
- Margin call occurs when equity falls below maintenance requirement; investor must deposit additional funds or securities
| Leverage Concept | Threshold |
|---|---|
| Reg T initial margin | 50% of purchase price |
| FINRA minimum maintenance | 25% equity |
| Firm maintenance (typical) | 25-35% equity |
Suitability
- Higher risk than unleveraged investing; potential to lose more than the original investment
- Not suitable for all investors - only appropriate for those with high risk tolerance and sufficient financial resources
Exam Tip: Gotchas
- Leverage amplifies both directions. A question about a leveraged portfolio losing value is testing whether you understand that the investor loses a larger percentage of equity than the portfolio's percentage decline.
Volatility Management
Volatility management techniques aim to control portfolio risk by reducing exposure during high-volatility periods.
Key Volatility Measures
| Measure | What It Measures |
|---|---|
| Standard deviation | Portfolio volatility (higher standard deviation = more volatile) |
| Beta | A security's volatility relative to the market (beta > 1 = more volatile than market) |
Volatility Management Methods
- Asset allocation shifts - moving to more conservative assets (bonds, cash) when volatility spikes
- Options hedging - buying protective puts or collars during volatile markets
- Volatility targeting - adjusting exposure to maintain a constant level of portfolio volatility
- Stop-loss orders - automatic sell orders triggered when a security falls to a specified price
Advisers have a fiduciary duty to ensure portfolio volatility matches the client's risk tolerance.
Think of it this way: Volatility is how bumpy the ride is. Two portfolios can both average 8% returns over 10 years, but the one with wild swings (up 30%, down 20%) feels very different from the one that steadily gains 7-9% each year. Managing volatility means smoothing the ride to match the client's comfort level.
Inverse Strategies
Inverse funds (inverse ETFs) seek to deliver the opposite of the daily performance of a benchmark index. If the S&P 500 falls 1%, a 1x inverse S&P 500 ETF aims to rise ~1% (before fees).
Leveraged Inverse Funds
- Leveraged inverse funds amplify the inverse return (e.g., 2x or 3x the opposite daily return)
- Daily reset mechanism; returns are calculated and reset each trading day
- Compounding decay (volatility drag) causes returns over longer periods to deviate significantly from the expected inverse multiple
Suitability
- NOT suitable for buy-and-hold investors - designed for short-term trading or hedging
- FINRA has warned that leveraged/inverse ETFs are generally unsuitable for retail investors holding beyond one trading session
Exam Tip: Gotchas
- The exam tests that leveraged and inverse ETFs reset daily. Over multiple days, compounding can cause significant deviation from the expected return. In a volatile, flat market, both leveraged and inverse ETFs can lose value even if the underlying index is unchanged. These products are unsuitable for long-term holding.
High-Frequency Trading
High-frequency trading (HFT) uses powerful computers and algorithms to execute a large number of trades at extremely high speeds (microseconds to milliseconds).
Key Characteristics
- Strategies include market making, arbitrage, and momentum trading
- HFT firms profit from very small price differences across markets or tiny bid-ask spreads
- Not a strategy available to retail investors - requires significant technology infrastructure and co-location at exchanges
Market Impact
- Advantages: Increases market liquidity, narrows bid-ask spreads
- Criticisms: Creates unfair advantages, may increase market volatility, "flash crashes"
- Regulatory scrutiny from SEC and FINRA regarding market fairness and stability
Exam Tip: Gotchas
- HFT is NOT available to retail investors. If a question asks what strategy is available only to institutional or proprietary traders, HFT is the answer.
- HFT can both help (tighter spreads) and hurt (flash crashes) markets. The exam tests both sides.