Portfolio and Account Analysis

Now that you understand the customer-specific factors that drive security selection, the next step is building and managing the portfolio itself. This section covers the tools and principles for constructing a portfolio that fits the customer's profile.

Diversification

• Diversification is the strategy of spreading investments across different asset classes, sectors, geographies, and individual securities to reduce overall portfolio risk
• Diversification reduces unsystematic (company-specific) risk but does NOT eliminate systematic (market) risk
• The effectiveness of diversification depends on the correlation between holdings (covered in detail in the next section)

Types of Diversification

• A portfolio of 100 technology stocks is NOT well-diversified because all holdings are in the same sector and subject to similar risks
• True diversification requires holdings that respond differently to market conditions

Exam Tip: Gotchas

• Diversification does NOT eliminate all risk. It eliminates unsystematic risk (company-specific, business risk, financial risk). Systematic risk (market risk, interest rate risk, inflation risk, political risk) affects all securities and cannot be diversified away. The exam frequently asks what type of risk diversification addresses.

Asset Allocation Principles

• Asset allocation is the process of dividing a portfolio among major asset categories (equities, fixed income, cash, alternatives) based on the customer's investment profile
• Asset allocation is widely considered the most important determinant of long-term portfolio performance, more significant than individual security selection or market timing
• Two primary approaches:

Think of it this way: Strategic allocation is the long-term plan. Tactical allocation is the short-term adjustment. A portfolio might have a strategic target of 60% stocks / 40% bonds but temporarily shift to 65% stocks / 35% bonds to capture an expected equity rally.

Rebalancing

• Rebalancing is the process of buying or selling assets to restore a portfolio to its target allocation after market movements cause drift
• Example: If a 60/40 stock/bond target portfolio drifts to 70/30 due to equity gains, the investor sells stocks and buys bonds to return to 60/40
• Rebalancing may trigger taxable events in non-qualified accounts (capital gains on sold positions)
• Rebalancing in a tax-deferred account (IRA, 401(k)) avoids current tax consequences

Exam Tip: Gotchas

• Asset allocation is the most important determinant of long-term performance. Not security selection, not market timing. The exam tests this distinction.
• Strategic allocation is long-term and rebalanced periodically; tactical allocation is short-term and actively adjusted. A common trap is confusing which approach changes with market conditions (tactical does, strategic does not).

Concentration Risk

• Concentration occurs when an outsized portion of a portfolio is in a single security, sector, asset class, or geographic region
• Concentration amplifies both upside potential and downside risk; the portfolio's performance becomes tied to that single position

Common sources of concentration:

• Employees holding large positions in employer stock (stock options, restricted stock, Employee Stock Purchase Plan (ESPP) shares)
• Inherited positions with large unrealized gains (tax consequences discourage selling)
• Sector-focused portfolios (e.g., all tech stocks)
• Representatives have a responsibility to identify concentration and discuss diversification strategies with the customer

Exam Tip: Gotchas

• An investor with a large unrealized gain may resist selling, but the concentration risk remains. A common exam scenario: an investor holds $500,000 in a single stock with a $50,000 cost basis. The rep should discuss strategies to reduce concentration (selling over time, hedging with protective puts, gifting to charity, or using exchange funds) even when the customer resists action.

Volatility

• Volatility measures the degree to which an investment's price fluctuates over time
• Higher volatility means greater uncertainty about returns; the investment may produce large gains or large losses
• Standard deviation is the most common statistical measure of volatility:
  • Measures how much individual returns deviate from the average return
  • A higher standard deviation indicates greater volatility (wider dispersion of returns)
  • Standard deviation measures total risk (both systematic and unsystematic)
• Volatility is not inherently bad; it represents opportunity for investors with long time horizons and high risk tolerance
• For income-focused or short-horizon investors, high volatility is generally unsuitable

Exam Tip: Gotchas

• Standard deviation measures total risk; beta measures only systematic risk. The exam tests this distinction frequently. If a question asks about "total risk," the answer is standard deviation. If it asks about "market risk" or "systematic risk," the answer is beta.

Tax Ramifications of Portfolio Decisions

Portfolio decisions carry potential tax consequences that a representative must consider:

• Tax considerations should inform but not override the investment recommendation. A suitable investment should not be avoided solely because of tax consequences