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Wealth Management · Topic lesson

Portfolio Allocation

How an advisor builds and keeps a client's mix: the return a blend can expect, the risk that comes with it, rebalancing back to the plan, the glide path as the client ages, and what a foreign sleeve adds.

5 chapters About 55 minutes0 of 5 complete
Start chapter 1

Most of what happens to a client's money is decided by the allocation: how much sits in equities, bonds and cash. Interviewers test whether you can put numbers on that. The blend's expected return and what the fee does to it. The risk of the mix, translated into a bad year in dollars. The trade that brings a drifted portfolio back to plan. The equity weight a client of a given age should hold, and what a foreign sleeve does to return and risk. This lesson follows a portfolio from the first blend to its international sleeve.

Two facts run through every chapter. Return blends linearly, so the expected return is the money-weighted average of the sleeves. Risk does not, because the sleeves do not move together: variances add, with a correlation term, and that is why mixing assets is worth doing. Everything else, from rebalancing bands to currency hedges, is those two facts applied.

  • Expect. The blended return, net of fees, and the equity weight a target needs.
  • Risk. Two-asset volatility, the bent line, and a one-in-twenty bad year in dollars.
  • Keep. Drift, the rebalancing trade, contributions instead of sales, and bands.
  • Age. The glide path: start, floor, slope, and what a later retirement does.
  • Abroad. Unhedged and hedged returns, the rate gap, and when hedging raises risk.
The rule that solves every question

Weight everything by money. Returns blend as weights × returns; variances blend as weights² × variances plus a cross term; trades are gaps between held and target on today's value. Performance attribution, the part of the old portfolio-math lesson this one does not cover, is taught in Hedge Fund Long / Short Equity.

A portfolio, from the first blend to its foreign sleeve

Each step points to the chapter that practices it.

  1. 1
    Expect the return

    Blend the sleeves; take off the fee.

    Chapter 1
  2. 2
    Price the risk

    Variance with a cross term; a bad year in dollars.

    Chapter 2
  3. 3
    Keep the mix

    Drift, the trade, contributions, bands.

    Chapter 3
  4. 4
    Age the mix

    A straight line to a floor at retirement.

    Chapter 4
  5. 5
    Go abroad

    Compound the currency; hedge with the rate gap.

    Chapter 5

Chapters

1

The return a mix can expect

10 min

A portfolio's expected return is the average of its parts, weighted by the money in each. Fees come straight off the top.

  • Blend three sleeves into one expected return
  • Take the fee off in dollars and in percent
  • Find the equity weight a plan's target return needs
  • Say why volatility does not blend the way return does
2

The risk that comes with it

12 min

More equity buys more expected return and costs more volatility, but the line is bent. Translate the bend into a bad year in dollars, and the client can decide.

  • Compute a two-asset portfolio's expected return and volatility
  • Turn volatility into a one-in-twenty bad year, in percent and dollars
  • Find the highest equity weight that keeps volatility at a target
  • Explain why the first bonds remove more risk than return
3

Keeping the mix where the plan put it

11 min

Markets move the allocation for you. Rebalancing trades it back, and the trade size is the gap between what the client holds and what the target says on today's value.

  • Compute the drifted weight after a market move
  • Size the trade that restores the target
  • Find the new money that rebalances without selling
  • Find the equity return that triggers a rebalancing band
4

Changing the mix as the client ages

10 min

Lots of equity early, less each year, a floor at retirement. The arithmetic is a straight line; the questions are how steep, what it means in dollars this year, and what moving the retirement date does.

  • Read an equity weight off a straight-line glide path
  • Turn this year's step into dollars moved
  • Find the age at which the path reaches a given weight
  • Say what a later retirement date does to the line
5

What a foreign sleeve adds

12 min

A US client in European shares makes two bets: the shares and the euro. Hedging removes the second, at a price set by interest rates, not by anyone's view.

  • Compound a local return and a currency move into a dollar return
  • Compute a hedged return from the interest-rate gap
  • Find the currency move at which hedging and not hedging tie
  • Say why hedging can raise volatility, and why foreign bonds are the stronger case