NISM Certifications · NISM-Series-X-A: Investment Adviser (Level 1)

Portfolio Construction Process: formula sheet

Full chapter guide

Key formulas

Order of the process: Client profiling → Objectives and constraints → IPS → Asset allocation → Security selection → Implementation → Monitoring and rebalancing; Exams often ask which step comes before or after another. Asset allocation comes before security selection.
Risk profile: Risk profile = Risk capacity + Risk tolerance (willingness); When the two differ, the lower of the two should generally guide the risk taken.
Return objective constraints: Constraints = Time horizon, Liquidity, Taxes, Legal and regulatory, Unique circumstances; Remember them as a checklist. Objectives are return and risk.
Portfolio weight: Weight of asset = Value of asset ÷ Total portfolio value; Used to check drift from the target allocation when rebalancing.
Overall risk level: Overall risk level = lower of (risk tolerance, risk capacity); If willingness is high but ability is low, the client should take low risk. Use the more conservative one.
Risk objective: Risk objective = f(risk tolerance, risk capacity); Both must be assessed. Neither alone is enough.
Return objective: Required return = (Required corpus ÷ Present value)^(1 ÷ n) − 1; Use for an absolute return need. Here n is the number of years. Check that the required return is realistic for the risk level.
Constraints (memory aid): Liquidity, Time horizon, Tax, Legal and regulatory, Unique circumstances; Five constraints. Objectives (risk and return) are not constraints.
IPS core structure: IPS = Objectives (risk, return) + Constraints + Benchmark + Review and rebalancing terms; Questions often ask which item belongs in an IPS.
Strategic allocation: Long-term target weights based on client profile; rebalance to targets; Anchor of the portfolio. Driven by goals, risk tolerance, horizon and long-run assumptions.
Tactical allocation: Actual weight = strategic weight ± short-term deviation; Deviations are temporary and bounded. The portfolio returns to the strategic mix.
Dynamic allocation: Weights change continuously or by rule as markets or client circumstances change; No fixed target to return to. Often rule-based.
Core-satellite: Portfolio = core (stable, low-cost, diversified) + satellites (active, smaller); A structure for combining passive and active holdings, not a timing method.
Weight of an asset class: Weight = value of asset class ÷ total portfolio value × 100; Use it to compare actual weights with targets.
Portfolio expected return: E(Rp) = w1 × R1 + w2 × R2; Simple weighted average. Weights must add up to 1. Correlation does not affect it.
Two-asset portfolio variance: σp² = w1²σ1² + w2²σ2² + 2 × w1 × w2 × ρ12 × σ1 × σ2; Portfolio standard deviation σp is the square root of this. Do not forget the final square root.
Covariance and correlation: Cov(1,2) = ρ12 × σ1 × σ2, so ρ12 = Cov(1,2) ÷ (σ1 × σ2); Correlation ranges from -1 to +1. Covariance is not limited to that range.
Special case ρ = +1: σp = w1σ1 + w2σ2; Risk is the plain weighted average. No diversification benefit.
Special case ρ = -1: σp = |w1σ1 - w2σ2|; Risk is zero when w1σ1 = w2σ2.
Capital Market Line: E(Rp) = Rf + [(E(Rm) - Rf) ÷ σm] × σp; Applies to efficient portfolios only. The slope is the market price of risk. Uses total risk σ, not beta.
Total risk split: Total risk = Systematic risk + Unsystematic risk; Only unsystematic risk is diversifiable.
Top-down sequence: Economy → Asset class → Sector/Industry → Security; Macro view first. Bottom-up reverses this: Security → Industry → Economy.
Active vs passive: Active: aims for return > benchmark; Passive: aims for return ≈ benchmark; Passive has lower cost and lower tracking error. Active has higher cost and a chance of outperformance or underperformance.
Net return: Net return ≈ Gross return − Expenses − Taxes; Compare products on after-cost, after-tax returns that match the client's tax bracket.
Selection filter: Suitability = Risk profile + Goal + Horizon + Liquidity + Cost + Tax; A product must pass all of these for the client, not only one.
Current weight: Weight of asset = Value of asset ÷ Total portfolio value; Compute on current market values, not on amounts originally invested.
Band check: Rebalance if weight > target + band, or weight < target − band; A 60% target with ±5% band triggers below 55% or above 65%. Exactly at the edge is usually not a breach.
Amount to trade: Trade amount = (Target weight × Total value) − Current value of asset; A positive result means buy; a negative result means sell.
CPPI cushion: Cushion = Portfolio value − Floor; Cushion is the amount that may be at risk.
CPPI risky exposure: Risky asset exposure = Multiplier × Cushion; Remainder goes to the safe asset. Exposure rises when portfolio value rises.

Quick revision

The process runs: know the client, write the IPS, set asset allocation, select products, implement, monitor and rebalance.
The IPS records goals, risk profile, constraints and the agreed approach to the portfolio.
Risk tolerance is willingness to take risk. Risk capacity is ability to bear loss.
When tolerance and capacity differ, the safer approach is to follow the lower of the two.
Asset allocation is the main driver of a portfolio's risk and return behaviour.
Strategic allocation sets long-term target weights. Tactical allocation makes short-term deviations from them.
Diversification works best when assets are not perfectly correlated.
Diversification reduces unsystematic (specific) risk, not systematic (market) risk.
Product selection must fit the allocation, the client's needs and costs.
Rebalancing brings weights back to target after market moves drift them.
Review the portfolio when the client's circumstances change, not only when markets move.
Read each caselet option against the client's stated constraints before choosing.

Common mistakes

Placing security selection before asset allocation. Fix: Remember that allocation sets the broad mix first. Selection fills each class afterwards.
Treating risk capacity and risk tolerance as the same thing. Fix: Capacity is financial ability to bear loss. Tolerance is psychological comfort. Use the lower one as the guide.
Treating risk tolerance and risk capacity as the same thing. Fix: Tolerance is willingness (psychological). Capacity is ability (financial). Test with the question: feeling or fact?
Choosing the higher of tolerance and capacity as the client's risk level. Fix: Use the lower of the two. A client who is willing but cannot afford losses should take less risk.
Treating tactical and dynamic allocation as the same thing. Fix: Tactical deviates temporarily from a strategic target and returns to it. Dynamic keeps adjusting with no fixed target to return to.
Saying strategic allocation is based on market forecasts. Fix: Strategic allocation is based on the client's goals, risk and horizon plus long-run assumptions. Market views drive tactical moves.
Reporting portfolio variance as the standard deviation. Fix: Always take the square root as the last step and check units.
Thinking correlation changes portfolio expected return. Fix: Expected return is the weighted average regardless of correlation. Only risk changes.
Mixing up top-down and bottom-up. Fix: Ask where the analysis starts. Economy first is top-down. Company or fund first is bottom-up.
Choosing a product on past returns alone. Fix: Check suitability, risk, consistency against the benchmark, and costs. Past performance does not guarantee future returns.

Exam tips

Learn the order of steps by heart. Many questions ask which step comes first, next or last.
Know the five constraints by name and be able to match a scenario to one of them.
If two risk options appear, check whether the scenario describes ability (capacity) or attitude (tolerance).
For rebalancing numbers, compute weights first, then the rupee amount to shift.
With negative marking of 25% of the question's marks, skip a question only if you cannot eliminate at least two options.
Look for keywords. Words like comfortable, nervous, anxious point to tolerance. Words like income, loans, dependants, net worth point to capacity.
When tolerance and capacity differ, the answer is almost always the lower one.
Know the five constraints by name. Options that list risk or return among them are traps.