Quick Answer
Match investments to the customer's whole profile (the most restrictive factor wins), diversify to erase unsystematic (company-specific) risk while systematic (market) risk stays, measure market sensitivity with beta (1.0 moves with the market), measure manager skill with alpha (return above the Capital Asset Pricing Model expectation), and build portfolios on the efficient frontier.
The whole unit on one sheet: profile the customer, split the risk, and read beta, alpha, the Capital Asset Pricing Model (CAPM), and Modern Portfolio Theory (MPT).
Customer-Specific Factors
- The investment profile = risk tolerance, time horizon, objectives, and liquidity needs. Weigh it as a whole; no single factor decides suitability alone.
- A short time horizon or high liquidity need overrides an aggressive risk tolerance. Treat conflicting profiles by the most restrictive factor.
- Objective progression, low to high risk: preservation of capital → current income → growth → speculation. Each step up adds return and risk.
- Growth is not speculation. Growth = steady appreciation from established companies; speculation accepts far higher risk for higher potential return.
- Liquidity need is about how fast funds might be needed, not the size of the investment.
Portfolio and Account Analysis
- Diversification spreads holdings across asset classes, sectors, geographies, and issuers; it reduces unsystematic risk only, never systematic risk.
- Asset allocation (the mix of broad asset classes) is the most important determinant of long-term performance, ahead of security selection or market timing.
- Strategic allocation = long-term targets, periodically rebalanced, does not change with markets. Tactical allocation = short-term deviations, actively adjusted, returns to target.
- Rebalancing in a taxable account may trigger capital gains; in a tax-deferred account (IRA, 401(k)) it has no current tax consequence.
- Standard deviation measures total risk (systematic + unsystematic); beta measures systematic risk only.
Systematic vs. Unsystematic Risk
- Systematic (market) risk hits the whole market, is non-diversifiable, and is mitigated only by hedging or asset allocation across uncorrelated classes. Measured by beta.
- Unsystematic (company-specific) risk is unique to one company or industry and can be eliminated by diversification (business risk, financial risk, security-specific liquidity risk).
- Correlation coefficient runs -1.0 to +1.0: +1.0 = no benefit, 0 = moderate benefit, -1.0 = maximum benefit (risk can theoretically be eliminated). Benefit begins as soon as correlation is below +1.0.
The One-Liners That Win Points
- Diversification erases unsystematic risk, never systematic risk.
- Beta = 1.0 moves with the market; beta > 1.0 is more volatile (aggressive); beta < 1.0 is less volatile (defensive). High beta amplifies gains AND losses.
- Portfolio beta is a weighted average of holdings' betas, not a simple average.
- Alpha = actual return minus CAPM expected return. Positive = manager added value; beating the market does not by itself mean positive alpha.
- Undervalued (buy) = actual return above CAPM expectation; overvalued (sell) = below it. Students reverse this.
- The efficient frontier is the best return for each risk level. Nothing sits above it; below it is suboptimal.
Numbers to Lock In
| Item | Value |
|---|---|
| Market (S&P 500) beta by definition | 1.0 |
| T-bill beta | approximately 0 |
| Correlation coefficient range | -1.0 to +1.0 |
| Capital loss offset against ordinary income | up to $3,000 per year |
| Long-term vs. short-term capital gain line | held more than 1 year = long-term |
| CAPM formula | Expected Return = Risk-Free Rate + Beta x (Market Return - Risk-Free Rate) |
| Portfolio beta | sum of (each holding's weight x its beta) |
Memory Aid: PRIME (the five systematic risks)
- Purchasing power risk (inflation)
- Reinvestment risk
- Interest rate risk
- Market risk
- Exchange rate risk
Top Gotchas
- The most restrictive factor governs. An "aggressive" customer with a 6-month horizon for a home purchase is treated by the short horizon and liquidity need, not the stated risk tolerance.
- Standard deviation is total risk; beta is systematic risk. A concentrated portfolio still carries unsystematic risk, so standard deviation tells the fuller story.
- Beating the market is not positive alpha. A fund up 15% versus a 10% market can still show negative alpha: beta 2.0, risk-free rate 3%, CAPM expected = 3% + 2.0(10% - 3%) = 17%, so alpha = 15% - 17% = -2%. Always compute the CAPM expected return first.
- CAPM starts at the risk-free rate, not zero. The market risk premium is market return MINUS the risk-free rate (Rf 3%, Rm 10% gives 7%, not 10%).
- Returning MORE than CAPM says = undervalued (buy). Returning less = overvalued (sell).
- Match the concentration-reduction method to the constraint. Only a sale raises cash; an exchange fund diversifies and defers the gain but raises none; a protective put or collar hedges but neither diversifies nor raises cash; a charitable gift fits only when the client wants to give.
One-Breath Recap
Profile the customer as a whole and let the most restrictive factor win, then diversify to wipe out company-specific risk while market risk stays behind. Beta measures that leftover market sensitivity (1.0 tracks the market), the Capital Asset Pricing Model sets the return you should demand for it, and alpha tells you whether the manager beat that benchmark. Modern Portfolio Theory ties it together on the efficient frontier, the best return for each level of risk.
Need more than the recap? This is a condensed summary. If it is not enough, read the full Portfolio Theory and Asset Allocation unit for the complete lesson.