Every concept, endless questions
Each concept is a small financial model. Read how it works, then draw a real interview question from it: forwards, backwards or what-if, with fresh numbers and a worked solution every time.
Forward runs a concept the usual way. Inverse runs it backwards, which is what separates understanding from memorizing.
Portfolio Allocation
5 conceptsExpected return of a blended allocation
A portfolio’s expected return is simply the average of its parts, weighted by how much money sits in each. That makes it the one portfolio number that is easy — and it is why the allocation decision dominates everything else an adviser does. Moving ten points from bonds to equities changes the expected return by a tenth of the gap between them, every year, for as long as the client holds it. Fees come straight off the top of that blend. Run the calculation backwards and it answers the question clients actually ask: how much equity do I need to hit the return my plan assumes?
Rebalancing trade size
Markets move the allocation for you. After a strong year for equities a 60/40 portfolio might be 66/34, carrying more risk than the client signed up for; after a crash it might be 50/50, carrying less. Rebalancing is the discipline of trading back to the agreed mix: selling what has done well and buying what has done badly. That feels wrong, which is exactly why it has to be a rule rather than a judgment call. The trade size is the gap between what the client holds and what the target says they should hold on today’s value, and new contributions can close that gap without selling anything.
Glide path
A 25-year-old’s biggest asset is forty years of future salary, and a bad decade in the market barely touches it. A 64-year-old’s biggest asset is the portfolio itself, and a bad year just before retirement can be permanent, because withdrawals start while prices are down. A glide path turns that into a schedule: lots of equity early, less each year, a floor at retirement. Target-date funds are exactly this. The arithmetic is a straight line, and the questions worth asking are how steep it is, what it means in dollars this year, and what moving the retirement date does to it.
Two-asset risk and return tradeoff
Every allocation is a point on a curve: more equity buys more expected return and costs more volatility. But the curve is bent, not straight, because stocks and bonds do not move in lockstep. That bend is why a little bond in an all-equity portfolio removes a lot of risk and very little return. Clients do not think in volatility, so the adviser translates: a one-in-twenty bad year, in dollars, is a number a client can decide whether they could live with. Run it backwards and the client’s tolerance for a bad year sets the equity weight.
Hedged versus unhedged international
An American who buys European shares makes two bets at once: one on the shares, and one on the euro. If the shares rise 8% but the euro falls 6% against the dollar, most of the gain disappears on the way home. Hedging removes the currency bet by selling euros forward, and the price of doing so is set by interest rates, not by anyone’s view of the euro: when dollar rates are higher than euro rates the hedge actually pays. For equities the currency adds a moderate amount of risk; for bonds it can swamp the asset entirely, which is why most advisers hedge foreign bonds and argue about foreign equities.