Basics of Portfolio Planning and Construction

Learning Objectives Coverage

LO1: Describe the reasons for a written investment policy statement (IPS)

Core Concept exam-focus

An Investment Policy Statement (IPS) is a written document that captures a client’s investment objectives and constraints, serving as the foundation of the portfolio management process. The IPS ensures systematic, disciplined investment management, prevents the kind of emotional decision-making that behavioral biases drive, provides legal documentation of fiduciary responsibilities, and creates accountability between client and advisor.

The IPS serves multiple purposes: it facilitates communication, documents objectives and constraints, provides a framework for portfolio construction, creates performance evaluation benchmarks, ensures continuity during personnel changes, protects against liability claims, and guides tactical adjustments. Without it, the portfolio management process lacks discipline and direction.

Benefits of Written IPS

For the Client:
- Forces articulation of realistic goals
- Creates measurable objectives
- Provides reference during market volatility
- Documents expectations and responsibilities
- Enables performance evaluation
For the Investment Manager:
- Clarifies mandate and constraints
- Provides guidance for decision-making
- Documents client understanding
- Protects against liability
- Facilitates consistent management

Formulas

No specific formulas for this LO - conceptual understanding

Practical Examples

Pension Fund IPS: Documents funding requirements, benefit obligations, time horizons, regulatory constraints
Individual Investor IPS: Captures retirement goals, risk tolerance, tax situation, liquidity needs
Endowment IPS: Specifies spending policy, investment horizon (perpetual), restrictions on investments

DeFi Application

DeFi IPS Components:
- Smart contract risk tolerance
- Protocol diversification requirements
- Impermanent loss thresholds
- Gas cost management strategies
- Bridge risk parameters
- Custody preferences (self vs protocol)
- Yield farming strategy guidelines
- Liquidation risk management

LO2: Describe the major components of an IPS

Core Concept

Definition: The IPS structure includes standardized sections covering client background, investment objectives, constraints, guidelines, evaluation criteria, and appendices containing supplementary information
Why it matters: A comprehensive IPS structure ensures all relevant factors are considered, documented, and regularly reviewed for effective portfolio management
Key components:
- Introduction and client description
- Statement of purpose
- Duties and responsibilities
- Procedures for updates
- Investment objectives
- Investment constraints
- Investment guidelines
- Evaluation and review
- Appendices

IPS Component Details

Introduction:
- Client description and background
- Source of wealth/funding
- Investment experience
- Family/beneficiary considerations
Statement of Purpose:
- Document objectives
- Define scope of relationship
- Establish guidelines framework
Duties and Responsibilities:
- Investment Manager: Security selection, trade execution, reporting
- Client: Provide information, approve IPS, review performance
- Custodian: Safekeeping, transaction settlement, reporting
Investment Objectives:
- Risk objectives (absolute/relative)
- Return objectives (nominal/real)
- Time horizon specification
Investment Constraints:
- Liquidity requirements
- Time horizon
- Tax considerations
- Legal/regulatory factors
- Unique circumstances
Investment Guidelines:
- Permissible asset classes
- Allocation ranges
- Rebalancing rules
- Prohibited investments

Formulas

Return Objective = (Future Value / Present Value)^(1/n) - 1
Real Return = Nominal Return - Inflation Rate (approximation)

Practical Examples

Sample IPS Structure:

I. Introduction
   - Client: Marie Gascon, age 45
   - Assets: €900,000
   - Income: €150,000 annually

II. Objectives
   - Return: 6.2% nominal
   - Risk: Moderate (10-15% volatility)

III. Constraints
   - Liquidity: €50,000 emergency fund
   - Horizon: 20 years to retirement
   - Taxes: 25% capital gains rate

DeFi Application

DeFi IPS Structure Additions:
- Protocol risk assessment criteria
- Smart contract audit requirements
- Oracle dependency guidelines
- Cross-chain exposure limits
- MEV protection strategies
- Governance participation policy
- Yield optimization parameters

LO3: Describe risk and return objectives and how they may be developed for a client

Core Concept exam-focus

Risk and return objectives quantify the client’s investment goals and risk tolerance, expressed either in absolute terms (specific targets like “8% nominal return”) or relative terms (“beat the benchmark by 1%”). These objectives must be internally consistent — a client cannot demand high returns with low risk — and the efficient frontier defines the feasible set. Properly specified objectives ensure portfolio construction aligns with client needs, enables performance measurement, and guides tactical decisions. The distinction between nominal vs. real, pre-tax vs. after-tax, and total return vs. income objectives all have practical implications for how the portfolio is structured.

Risk Objective Specifications

Absolute Risk Objectives:
- Maximum loss tolerance (e.g., -10% in any year)
- Value at Risk (VaR) limits
- Volatility targets
- Drawdown constraints
Relative Risk Objectives:
- Tracking error limits
- Information ratio targets
- Beta constraints
- Factor exposure limits

Return Objective Development

Capital Preservation: Real return ≥ 0%
Income Generation: Current yield targets
Capital Appreciation: Growth objectives
Total Return: Combined income + growth

Formulas

Required Return = [(FV/PV)^(1/n) - 1]
VaR(95%) = μ - 1.65σ
Tracking Error = σ(Rp - Rb)
Real Return Required = (1 + Nominal) / (1 + Inflation) - 1

Practical Examples

Marie Gascon Return Calculation:

Goal: €2,000,000 (real) in 20 years
Inflation: 2% annually
Nominal goal: €2,000,000 × 1.02^20 = €2,971,895
Current assets: €900,000
Required return: (2,971,895/900,000)^(1/20) - 1 = 6.2%

Risk Objective Examples:
- Japanese investor: “Do not lose more than ¥1 billion in 12 months”
- Pension fund: “Maintain funded ratio above 90%”
- Individual: “95% probability of not losing more than 15%“

DeFi Application

DeFi Risk/Return Objectives:
- Stablecoin farming: 8-12% APY, minimal IL risk
- Blue-chip LP: 15-25% APY, moderate IL tolerance
- Leveraged yield: 30%+ APY, liquidation management
- Risk metrics: TVL stability, protocol revenue, audit scores

LO4: Explain the difference between the willingness and the ability (capacity) to take risk

Core Concept exam-focus

Risk tolerance comprises two distinct components: willingness (psychological/subjective attitude toward risk) and ability (objective financial capacity to withstand losses). Willingness is shaped by personality, past experience, and the kinds of behavioral biases that make investors deviate from rational decisions. Ability is determined by financial factors: time horizon, income stability, wealth level, and liquidity needs.

When willingness and ability conflict, the more conservative assessment typically prevails. An investor who is emotionally willing to take on high risk but lacks the financial capacity to absorb losses should be counseled toward a conservative allocation. Conversely, an investor with high capacity but low willingness may benefit from education about risk-return trade-offs and the long-term cost of excessive conservatism.

Ability to Bear Risk Factors

Time Horizon: Longer = higher ability
Expected Income: Stable/growing = higher ability
Wealth Level: Higher wealth = higher ability
Liquidity Needs: Lower needs = higher ability
Liabilities: Fewer obligations = higher ability
Insurance Coverage: Better coverage = higher ability
Human Capital: Higher/stable = higher ability
Goals Flexibility: More flexible = higher ability

Willingness to Take Risk Assessment

Questionnaire Methods:
- Psychometric scoring (1-20 scale)
- Scenario-based questions
- Loss aversion measurements
- Past behavior analysis
Behavioral Indicators:
- Investment experience
- Past reactions to losses
- Stated preferences
- Lifestyle choices

Risk Tolerance Resolution Matrix

                    | Ability Below Average | Ability Above Average
--------------------|----------------------|----------------------
Willingness Below   | Below-Average        | Education needed;
Average             | Risk Tolerance       | Conservative chosen
--------------------|----------------------|----------------------
Willingness Above   | Education needed;    | Above-Average
Average             | Conservative chosen  | Risk Tolerance

Formulas

Risk Capacity Score = f(Time, Income, Wealth, Liquidity, Liabilities)
Overall Risk Tolerance = MIN(Willingness, Ability) [conservative approach]

Practical Examples

Henri Gascon (High/High):
- Age 30, €250k salary, €1M savings
- 20-year horizon, minimal obligations
- Result: High risk tolerance appropriate
Jacques Gascon (Low/High Willingness):
- Age 40, volatile €40k income
- €100k mortgage, 4 children
- Result: Must reduce to match low ability

DeFi Application

DeFi Risk Assessment:
- Technical ability: Understanding of smart contracts, DeFi mechanics
- Financial ability: Capital for gas, loss absorption capacity
- Willingness factors: Comfort with innovation, regulatory uncertainty
- Resolution approach: Start conservative, increase with experience

LO5: Describe the investment constraints and their implications

Core Concept exam-focus

Investment constraints are limitations on portfolio composition arising from client circumstances, preferences, or external factors that restrict the investment opportunity set. While constraints reduce the feasible set of portfolios (pushing the efficient frontier rightward), they are essential for ensuring suitability and regulatory compliance. The five major constraints form the mnemonic TTLLU: Time horizon, Tax concerns, Liquidity requirements, Legal/regulatory factors, and Unique circumstances. Each directly impacts how portfolios are constructed and which assets are permissible.

Liquidity Requirements

Types:
- Ongoing expenses: Regular withdrawals
- Emergency reserves: 3-6 months expenses
- Negative liquidity events: Planned major purchases
- Positive liquidity events: Expected inflows
Implications:
- Higher cash/money market allocation
- Reduced allocation to illiquid assets
- Liquidity tiering strategy needed

Time Horizon Considerations

Classifications:
- Short-term: < 3 years
- Intermediate: 3-10 years
- Long-term: > 10 years
Multi-stage horizons:
- Pre-retirement accumulation
- Early retirement
- Late retirement/legacy

Tax Concerns

Considerations:
- Current vs deferred taxation
- Capital gains vs income rates
- Tax-loss harvesting opportunities
- Estate tax planning

After-tax return calculation:

r_after-tax = r_pre-tax × (1 - tax_rate)

Legal and Regulatory Factors

Prudent investor rule
ERISA requirements (US pensions)
UCITS regulations (European funds)
Prohibited transaction rules
Concentration limits

Unique Circumstances

ESG restrictions
Concentrated positions
Illiquid holdings
Social/religious preferences
Regulatory requirements

Formulas

Liquidity Ratio = Liquid Assets / Near-term Obligations
After-tax Return = Pre-tax Return × (1 - Tax Rate)
Time-weighted Liquidity Need = Σ(Cash Flow_t / (1+r)^t)

Practical Examples

Pension Fund Constraints (Switzerland):

Equities: Max 50%
Real Estate: Max 30%
Foreign Currency: Max 30% unhedged
Alternative Investments: Max 15%

DeFi Application

DeFi-Specific Constraints:
- Liquidity: Exit liquidity in DEXs, unlock periods
- Time: Vesting schedules, bonding periods
- Tax: Crypto tax treatment, DeFi income classification
- Legal: Regulatory uncertainty, KYC requirements
- Unique: DAO governance rights, slashing risks

LO6: Explain the specification of asset classes in relation to asset allocation

Core Concept

Definition: Asset classes are groups of securities with similar characteristics, risk-return profiles, and correlations that form the building blocks of strategic asset allocation
Why it matters: Proper asset class specification enables efficient portfolio construction, risk budgeting, and performance attribution while ensuring comprehensive market coverage
Specification criteria:
- Homogeneous within class
- Mutually exclusive
- Diversifying to other classes
- Collectively exhaustive
- Sufficient capacity

Traditional Asset Class Hierarchy

1. Cash/Money Market
   - T-bills
   - Commercial paper
   - Money market funds

2. Fixed Income
   - Government bonds
   - Corporate bonds
   - Municipal bonds
   - High-yield bonds
   - Inflation-linked bonds

3. Equities
   - Domestic large-cap
   - Domestic small-cap
   - International developed
   - Emerging markets

4. Real Assets
   - Real estate
   - Commodities
   - Infrastructure
   - Natural resources

5. Alternatives
   - Private equity
   - Hedge funds
   - Managed futures

Asset Class Selection Criteria

Expected return differential
Risk reduction potential
Correlation benefits
Implementation costs
Tax efficiency
Liquidity provision

Formulas

Correlation Benefit = 1 - ρ(i,j)
Diversification Ratio = σ_equal-weight / σ_optimized
Asset Class Sharpe = (E(R) - Rf) / σ

Practical Examples

Progressive Insurance Allocation:

Fixed Income: 76.9%
Cash: 10.4%
Equities: 10.2%
Preferred Stock: 2.5%

University Endowment:

Public Equity: 25%
Private Equity: 25%
Absolute Return: 20%
Real Assets: 20%
Fixed Income: 10%

DeFi Application

DeFi Asset Class Framework:

1. Stablecoins (Cash Equivalent)
   - Centralized (USDC, USDT)
   - Decentralized (DAI, FRAX)

2. Blue-chip Crypto (Core Holdings)
   - BTC (digital gold)
   - ETH (digital oil)

3. DeFi Protocols (Equity-like)
   - DEX tokens (UNI, SUSHI)
   - Lending (AAVE, COMP)

4. Yield-bearing (Income)
   - LP tokens
   - Staking derivatives

5. Alternative Strategies
   - Leveraged yield farming
   - Options vaults
   - Perpetual funding

LO7: Describe the principles of portfolio construction and the role of asset allocation

Core Concept exam-focus asset-allocation

Portfolio construction is the implementation of the investment strategy through security selection and weighting, with strategic asset allocation (SAA) being the primary determinant of long-term returns and risk. The landmark Brinson, Hood, and Beebower study showed that 90%+ of return variation comes from asset allocation decisions rather than security selection or market timing. This finding underscores why the IPS and its target allocation are so important — getting the asset class mix right matters far more than picking individual stocks or bonds. Construction approaches include top-down vs. bottom-up, strategic vs. tactical, passive vs. active, and the core-satellite model that many institutional investors employ.

Portfolio Construction Process

Capital Market Expectations:
- Expected returns by asset class
- Risk (volatility) estimates
- Correlation matrix
Strategic Asset Allocation (SAA):
- Long-term target weights
- Policy portfolio benchmark
- Rebalancing ranges
Tactical Asset Allocation (TAA):
- Short-term deviations
- Market timing overlays
- Risk budgets
Security Selection:
- Active vs passive implementation
- Manager selection
- Direct investment

Asset Allocation Approaches

Mean-Variance Optimization:
- Efficient frontier construction
- Utility maximization
- Constraint incorporation
Risk Parity:
- Equal risk contribution
- Leverage utilization
- Volatility targeting
Factor-Based:
- Risk factor exposure
- Smart beta implementation
- Multi-factor models

Formulas

Portfolio Return = Σ(w_i × R_i)
Portfolio Variance = ΣΣ(w_i × w_j × σ_i × σ_j × ρ_ij)
Utility = E(R) - 0.5 × A × σ²
Information Ratio = (R_p - R_b) / TE

Practical Examples

ABP Pension Fund SAA:

Equity: 36%
  - Developed: 27%
  - Emerging: 9%

Fixed Income: 37%
  - Government: 13%
  - Corporate: 13%
  - Inflation-linked: 8%
  - EM Debt: 3%

Alternatives: 27%
  - Real Estate: 10%
  - Private Equity: 5%
  - Hedge Funds: 4%
  - Commodities: 5%
  - Infrastructure: 3%

DeFi Application defi-application asset-allocation

The core-satellite approach translates elegantly to DeFi portfolio construction. The core allocation (50—60%) holds blue-chip crypto assets — BTC, ETH, and a stablecoin buffer — providing broad market exposure with relatively lower protocol risk. The satellite allocation (40—50%) pursues yield through DeFi-native strategies: governance tokens, LP positions, and emerging protocol exposure. This structure mirrors how Yearn Finance vaults combine stable yield generation with higher-risk strategy overlays.

Core (50-60%):                    Satellite (40-50%):
  - BTC: 25%                       - Blue-chip DeFi: 15%
  - ETH: 25%                       - Yield strategies: 15%
  - Stablecoins: 10%               - Emerging protocols: 10%

Risk Management:
  - Max protocol exposure: 10%
  - Chain diversification required
  - Regular rebalancing quarterly

The risk budget should enforce protocol concentration limits and chain diversification requirements, with quarterly rebalancing to maintain target allocations.

LO8: Describe how ESG considerations may be integrated into portfolio planning

Core Concept

Definition: ESG integration involves systematically incorporating environmental, social, and governance factors into investment analysis and portfolio construction to improve risk-adjusted returns and align with values
Why it matters: ESG factors can materially impact investment performance, represent emerging risks/opportunities, and increasingly influence asset flows and regulations
Integration dimensions:
- Risk mitigation
- Alpha generation
- Values alignment
- Regulatory compliance

ESG Integration Approaches

Negative Screening (Exclusion):
- Exclude harmful sectors/companies
- Common exclusions: tobacco, weapons, coal
- ~20% of global AUM uses exclusions
Positive Screening (Best-in-class):
- Select ESG leaders within sectors
- Maintain sector neutrality
- Focus on improvement trajectory
ESG Integration:
- Systematic factor inclusion
- Materiality assessment
- Risk-return optimization
Thematic Investing:
- Climate solutions
- Social impact
- Sustainable development goals
Active Ownership:
- Proxy voting
- Shareholder engagement
- Collaborative initiatives
Impact Investing:
- Measurable positive impact
- Financial return requirement
- Additionality principle

ESG Materiality Framework

Environmental:          Social:                Governance:
- Climate change       - Labor practices      - Board composition
- Resource depletion   - Product safety       - Executive compensation
- Waste/pollution      - Data security        - Audit quality
- Biodiversity         - Human rights         - Business ethics
- Water scarcity       - Community relations  - Tax transparency

ESG Performance Metrics

Carbon intensity: tCO2e / $M revenue
Board diversity: % independent/female directors
Safety record: Lost time injury frequency
ESG scores: MSCI, Sustainalytics ratings

Formulas

ESG-Adjusted Return = Base Return + ESG Alpha - ESG Risk Penalty
Carbon Footprint = Σ(Holdings × Carbon Intensity)
ESG Tilt = (ESG Score_Portfolio / ESG Score_Benchmark) - 1

Practical Examples

Mountain Materials Case:

Pre-ESG Base Case IRR: 15.0%
Environmental compliance: -5% margin impact
Safety concerns: -2x multiple reduction
Post-ESG Base Case IRR: 5.0%
Portfolio action: Reduce from 1.5% to 0.5%

Norwegian Sovereign Fund:

Exclusions: 170+ companies
Observation list: 30+ companies
Climate criteria: Coal >30% revenue
Active ownership: 11,000+ companies

DeFi Application

DeFi ESG Considerations:

Environmental:
- Consensus mechanism (PoW vs PoS)
- Carbon footprint per transaction
- Renewable energy usage
Social:
- Financial inclusion metrics
- Community governance participation
- Fair launch vs VC allocation
- Protocol accessibility
Governance:
- DAO structure and voting
- Token distribution
- Treasury management
- Upgrade mechanisms
- Multi-sig security
DeFi ESG Metrics:
- Energy per transaction (Wh/tx)
- Nakamoto coefficient (decentralization)
- Gini coefficient (token distribution)
- Governance participation rate
- Protocol revenue sustainability

Core Concepts Summary (80/20 Principle)

The 20% You Must Know

IPS is the Foundation: Documents objectives, constraints, and guidelines - without it, portfolio management lacks discipline and accountability
Risk Tolerance = MIN(Willingness, Ability): Conservative approach prevails when there’s conflict
Five Constraints (TTLLU): Time, Tax, Liquidity, Legal, Unique - each directly impacts feasible portfolios
Asset Allocation Dominates: 90%+ of return variation from allocation, not selection
ESG is Mainstream: No longer optional - material to risk/return and increasingly required

The 80% That Builds Expertise

IPS components and structure details
Risk/return objective specifications
Constraint quantification methods
Asset class selection criteria
Portfolio construction techniques
ESG integration approaches
Performance attribution methods
Rebalancing strategies

Comprehensive Formula Sheet

Return Calculations

Required Return = [(Future Value / Present Value)^(1/n)] - 1
Real Return = (1 + Nominal Return) / (1 + Inflation) - 1
After-tax Return = Pre-tax Return × (1 - Tax Rate)
Geometric Mean Return = [(1+r₁) × (1+r₂) × ... × (1+rₙ)]^(1/n) - 1

Risk Measures

Portfolio Variance = ΣΣ(wᵢ × wⱼ × σᵢ × σⱼ × ρᵢⱼ)
Value at Risk (95%) = μ - 1.65σ
Value at Risk (99%) = μ - 2.33σ
Tracking Error = σ(Rₚ - Rᵦ)
Downside Deviation = √[Σ(Min(Rᵢ - MAR, 0)²) / n]

Portfolio Construction

Utility Function = E(R) - λσ²/2
  where λ = risk aversion parameter

Sharpe Ratio = (E(R) - Rₑ) / σ
Information Ratio = (Rₚ - Rᵦ) / Tracking Error
Sortino Ratio = (R - MAR) / Downside Deviation

Asset Allocation

Strategic Weight = Long-term Target %
Tactical Range = Strategic ± Allowable Deviation
Rebalancing Trigger = |Current - Target| > Threshold
Contribution to Return = wᵢ × Rᵢ
Contribution to Risk = wᵢ × ∂σₚ/∂wᵢ

ESG Metrics

Carbon Intensity = Total Emissions / Total Revenue
ESG Score = Σ(Factor Weight × Factor Score)
Exclusion Impact = Universe Size Pre / Universe Size Post
ESG Tilt = Portfolio ESG Score / Benchmark ESG Score

HP 12C Calculator Sequences

Required Return Calculation

Example: €900,000 grows to €2,971,895 in 20 years
[f] [FIN]           Clear financial registers
900000 [CHS] [PV]   Present value (negative for investment)
2971895 [FV]        Future value
20 [n]              Number of periods
[i]                 Compute interest rate
Result: 6.17%

Real Return Calculation

Example: 8% nominal return, 3% inflation
1.08 [ENTER]        1 + nominal return
1.03 [÷]           Divide by (1 + inflation)
1 [-]              Subtract 1
100 [×]            Convert to percentage
Result: 4.85%

After-tax Return

Example: 10% return, 25% tax rate
10 [ENTER]          Pre-tax return
.25 [×]            Multiply by tax rate
[CHS]              Change sign
10 [+]             Add to original return
Result: 7.5%

Portfolio Return (2 assets)

Example: 60% stocks (12% return), 40% bonds (5% return)
.60 [ENTER]         Weight of stocks
12 [×]             Times stock return
.40 [ENTER]         Weight of bonds
5 [×]              Times bond return
[+]                Add components
Result: 9.2%

Practice Problems

Basic Level

IPS Purpose: List three reasons why a written IPS is essential for portfolio management.
Risk Tolerance: An investor has high willingness but low ability to take risk. What risk level should be assigned?
Constraints: Identify which constraint category each belongs to:
- Need for $50,000 annual income
- Retirement in 5 years
- No tobacco investments
- 401(k) contribution limits

Intermediate Level

Return Calculation: A client needs $2 mi ll i o nin 15 ye a rs an d ha s$ 800,000 today. What annual return is required?
Asset Allocation: Given correlations and returns:
- Stocks: E(R)=10%, σ=20%
- Bonds: E(R)=5%, σ=8%
- Correlation: 0.3 Calculate portfolio return and risk for 70/30 stocks/bonds.
ESG Integration: A coal company represents 2% of the index. After ESG screening, how does excluding it affect:
- Tracking error?
- Sector exposure?
- Carbon footprint?

Advanced Level

Multi-period Planning: Design an IPS for:
- Age 35, $500 ka sse t s,$ 150k income
- Goals: Retire at 60, $3M target
- Constraints: Two children’s education
- Risk: Moderate tolerance Include objectives, constraints, and allocation.
Risk Resolution: Compare two investors:
- A: High income, short horizon, aggressive
- B: Low income, long horizon, conservative Determine appropriate risk levels with justification.
ESG Portfolio Construction: Create a portfolio that:
- Excludes fossil fuels
- Maintains market exposure
- Targets carbon intensity 50% below benchmark
- Achieves similar expected return

DeFi Applications & Real-World Examples

DeFi Portfolio IPS Framework

1. Objectives
   - Yield target: 15-20% APY
   - Risk: Maximum 30% drawdown
   - Time: 2-year minimum

2. Constraints
   - Liquidity: 20% in stables/majors
   - Platform: Max 25% per protocol
   - Chain: Minimum 3 chains
   - Audit: Required for >10% positions

3. Guidelines
   - Rebalancing: Monthly
   - Yield harvesting: Weekly
   - Risk monitoring: Daily
   - Governance: Active participation

4. Evaluation
   - Benchmark: DeFi Pulse Index
   - Risk metrics: Sharpe, max drawdown
   - On-chain: TVL stability, utilization

Traditional-DeFi Hybrid Portfolio

Traditional (60%):
- Equities: 35%
- Bonds: 20%
- Real Estate: 5%

DeFi (40%):
- BTC/ETH: 20%
- Stablecoins: 10%
- DeFi Protocols: 7%
- Yield Strategies: 3%

Integration Benefits:
- Correlation: <0.3 with traditional
- Yield enhancement: +3-5% portfolio
- 24/7 liquidity access
- Programmable rebalancing

Real-World Case Studies

Case 1: Family Office DeFi Integration

Situation: $50M family office seeking yield
Solution: 10% allocation to DeFi
Implementation:
- 5% blue-chip crypto (BTC/ETH)
- 3% stable yield (lending protocols)
- 2% experimental (new protocols)
Results: +2% portfolio yield, <5% volatility increase

Case 2: DAO Treasury Management

Entity: $100M protocol treasury
IPS Elements:
- Preserve runway: 18 months expenses
- Growth target: Outperform ETH
- Constraints: No competing protocols
Allocation:
- Stablecoins: 30%
- ETH: 40%
- Own token: 20%
- Strategic investments: 10%

Common Pitfalls & Exam Tips

Common Mistakes

Confusing willingness with ability - They’re independent
Ignoring constraint hierarchy - Legal always overrides preferences
Over-specifying asset classes - Keep mutually exclusive
Focusing on returns only - Risk objectives equally important
Static IPS - Must update with circumstances

Exam Strategy

IPS questions: Always identify objectives before constraints
Risk tolerance: Conservative wins in conflicts
Time horizon: Multi-stage requires separate analysis
Asset allocation: Dominates returns (>90% variation)
ESG: Not just exclusion - integration improves risk/return

Key Distinctions

Strategic vs Tactical: Long-term targets vs short-term tilts
Absolute vs Relative: Specific goals vs benchmark comparison
Nominal vs Real: Before vs after inflation
Risk capacity vs tolerance: Can bear vs willing to bear

Key Takeaways

Must Remember

IPS is legally binding and protects both parties
Risk tolerance conflicts resolve conservatively
Asset allocation determines 90%+ of return variation
Constraints trump preferences in portfolio construction
ESG integration is risk management, not just values

Practical Applications

Always document investment decisions in writing
Reassess risk tolerance when circumstances change
Focus effort on asset allocation over security selection
Consider all five constraints before investing
ESG factors have material financial impact

DeFi Considerations

Add DeFi-specific sections to traditional IPS
Protocol risk assessment critical
Higher yields compensate for additional risks
Governance participation adds value
Technical ability affects risk capacity

Cross-References & Additional Resources

Quantitative Methods — Portfolio math, statistics, probability
Economics — Macro factors affecting allocation
Equity Investments — Security selection within allocation
Fixed Income — Duration matching for liabilities
Derivatives — Risk management overlays
Alternative Investments — Allocation to alternatives
Ethics — Fiduciary duty, suitability

External Resources

Finance IPS templates
GIPS standards for performance reporting
PRI (Principles for Responsible Investment)
TCFD climate risk framework
DeFi Safety protocol ratings

DeFi Resources

DeFi Pulse for TVL metrics
Dune Analytics for on-chain data
DeBank for portfolio tracking
Zapper/Zerion for management
Immunefi for security research

Review Checklist

Conceptual Understanding

Can explain why written IPS is essential
Know all major IPS components
Understand risk vs return objectives
Can distinguish willingness from ability
Know all five constraints (TTLLU)
Understand asset class specification
Can explain asset allocation importance
Know six ESG integration approaches

Calculation Proficiency

Application Skills

Can resolve risk tolerance conflicts
Can develop appropriate objectives
Can identify binding constraints
Can construct basic allocations
Can integrate ESG considerations
Can adapt IPS for DeFi

Exam Readiness

Memorized IPS structure
Know constraint categories
Understand risk resolution matrix
Can identify ESG approaches
Remember 90% allocation rule
Can handle multi-stage problems

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Basics of Portfolio Planning and Construction

Basics of Portfolio Planning and Construction

Learning Objectives Coverage

LO1: Describe the reasons for a written investment policy statement (IPS)

Core Concept exam-focus

Benefits of Written IPS

Formulas

Practical Examples

DeFi Application

LO2: Describe the major components of an IPS

Core Concept

IPS Component Details

Formulas

Practical Examples

DeFi Application

LO3: Describe risk and return objectives and how they may be developed for a client

Core Concept exam-focus

Risk Objective Specifications

Return Objective Development

Formulas

Practical Examples

DeFi Application

LO4: Explain the difference between the willingness and the ability (capacity) to take risk

Core Concept exam-focus

Ability to Bear Risk Factors

Willingness to Take Risk Assessment

Risk Tolerance Resolution Matrix

Formulas

Practical Examples

DeFi Application

LO5: Describe the investment constraints and their implications

Core Concept exam-focus

Liquidity Requirements

Time Horizon Considerations

Tax Concerns

Legal and Regulatory Factors

Unique Circumstances

Formulas

Practical Examples

DeFi Application

LO6: Explain the specification of asset classes in relation to asset allocation

Core Concept

Traditional Asset Class Hierarchy

Asset Class Selection Criteria

Formulas

Practical Examples

DeFi Application

LO7: Describe the principles of portfolio construction and the role of asset allocation

Core Concept exam-focus asset-allocation

Portfolio Construction Process

Asset Allocation Approaches

Formulas

Practical Examples

DeFi Application defi-application asset-allocation

LO8: Describe how ESG considerations may be integrated into portfolio planning

Core Concept

ESG Integration Approaches

ESG Materiality Framework

ESG Performance Metrics

Formulas

Practical Examples

DeFi Application

Core Concepts Summary (80/20 Principle)

The 20% You Must Know

The 80% That Builds Expertise

Comprehensive Formula Sheet

Return Calculations

Risk Measures

Portfolio Construction

Asset Allocation

ESG Metrics

HP 12C Calculator Sequences

Required Return Calculation

Real Return Calculation

After-tax Return

Portfolio Return (2 assets)

Practice Problems

Basic Level