Portfolio Management — Study Notes

CFA® Level I topic weight 8–12% · where the risk, return and CAPM machinery comes together

The portfolio management process

Three steps: planning (understand the client, write the investment policy statement), execution (asset allocation, security analysis, construction), and feedback (monitoring, rebalancing, performance evaluation). Exam questions often ask which step a described activity belongs to.
Investment policy statement (IPS): the governing document. Risk and return objectives come first; then the constraints, memorized as L-L-T-T-U — liquidity, legal/regulatory, time horizon, tax, and unique circumstances. The risk objective must reconcile ability to take risk (horizon, wealth, obligations) with willingness (attitude) — when they conflict, the more conservative governs and the mismatch is discussed with the client.
Client types: know the broad risk profiles — defined-benefit pensions and endowments have long horizons and higher risk tolerance; banks and insurers hold short-horizon, liability-driven, conservative portfolios; individuals vary with life-cycle stage.

Risk and return: the two-asset machinery

Portfolio return is always the weighted average of component returns. Portfolio risk is not — unless correlation is exactly +1. That gap is the diversification benefit.
Two-asset variance: σ²_p = w₁²σ₁² + w₂²σ₂² + 2w₁w₂ρ₁₂σ₁σ₂. Lower ρ → lower portfolio risk, all else equal; the exam loves asking what happens to the frontier as correlation falls.
Efficient frontier: the set of portfolios with the highest expected return per level of risk; the global minimum-variance portfolio anchors its left end. Portfolios below the frontier are attainable but inefficient.
Indifference curves for a risk-averse investor slope upward in risk–return space; steeper curves mean more risk aversion. The optimal portfolio is the tangency of the highest attainable indifference curve with the capital allocation line.

CML vs SML — the classic exam distinction

Capital market line (CML): combinations of the risk-free asset and the market portfolio; the x-axis is total risk (σ). Only efficient, well-diversified portfolios plot on the CML.
Security market line (SML): plots the CAPM — E(R_i) = R_f + β_i[E(R_m) − R_f] — and its x-axis is systematic risk (β). Any correctly priced security or portfolio, diversified or not, plots on the SML.
Beta: β_i = Cov(R_i, R_m) / σ²_m = ρ_i,mσ_i/σ_m. Total risk = systematic + unsystematic; diversification eliminates only the unsystematic part, so the market prices only β.
Over/under-valued via CAPM: if a security’s forecast return is above its CAPM-required return it plots above the SML and is undervalued (buy); below the SML means overvalued.

Performance measures

Sharpe ratio = (R_p − R_f)/σ_p — excess return per unit of total risk; the right measure when the portfolio is the investor’s entire wealth.
Treynor measure = (R_p − R_f)/β_p and Jensen’s alpha = R_p − [R_f + β_p(R_m − R_f)] — both use systematic risk, appropriate for a portfolio held alongside others.
M² restates the Sharpe result as a return figure directly comparable with the market return — same ranking as Sharpe, easier to interpret.

Behavioral biases and risk management

Cognitive errors vs emotional biases: cognitive errors (anchoring, confirmation, hindsight, availability, illusion of control, conservatism, representativeness, mental accounting, framing) stem from faulty reasoning and are easier to correct with information; emotional biases (loss aversion, overconfidence, self-control, status quo, endowment, regret aversion) stem from feelings and are usually accommodated rather than corrected.
Loss aversion vs risk aversion: loss aversion means losses hurt more than equivalent gains please — producing the disposition effect of selling winners too early and holding losers too long.
Risk management framework: risk governance sits at the top (risk tolerance set by the board), then risk identification and measurement, then monitoring and mitigation. The goal is not to minimize risk but to take the right risks at the chosen level — risk budgeting allocates the tolerance across activities.
Financial vs non-financial risks: market, credit and liquidity risks are financial; operational, legal, settlement, solvency and model risks are non-financial. Methods to modify risk: avoid, accept (self-insure), transfer (insurance), or shift (derivatives).

Common traps

Putting a non-diversified security “on the CML” — individual securities plot on the SML, not the CML; the CML holds only efficient combinations of the market portfolio and the risk-free asset.
Averaging standard deviations — portfolio σ is a weighted average only in the ρ = +1 special case; otherwise it is lower.
Using Sharpe when Treynor is asked (or vice versa) — check whether the question frames the portfolio as the whole of the investor’s wealth (total risk) or one sleeve among many (systematic risk).
Classifying loss aversion as a cognitive error — it is emotional; anchoring and confirmation are cognitive.
Writing constraints into the objectives — the IPS return and risk objectives are distinct from the L-L-T-T-U constraints, and exam items test which bucket a fact belongs to.

For exam preparation reference only — original condensed summaries of publicly known Level I curriculum concepts. Independent study aid. CFA Institute does not endorse, promote, or warrant the accuracy or quality of this product. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.