The ChoosaBroker Trading Academy
1.3. Portfolio Management
Money does not grow by itself. You will have to make it grow for you. And the only way to do that is by investing in a portfolio of assets that can help you earn enough returns to meet your financial goals. Like everything else in life, building a profitable investment portfolio requires time and effort. In this lesson, we will learn about:
What is Portfolio Management?
Portfolio management is defined as the art and science of managing an individual’s investments in diverse assets such as stocks, bonds, and real estate so that he earns the maximum profits within his stipulated time frame. The best portfolio management practices are based on the principle of maximizing returns for an investor, keeping in mind his or her income, investment capital, risk appetite and expected rate of return. The main objectives of portfolio management are –
Elements of Portfolio Management
The key elements of an ideal portfolio are briefly explained below:
Asset Allocation –
- The most important ingredient in effective portfolio management is to opt for a long-term mix of the various asset classes. Different assets exhibit different levels of volatility and seldom move in tandem. Asset allocation tries to optimize the risk management process by investing in a mix of assets that bear low correlation to each other. A case in point is the high negative correlation between stocks and gold, making both integral components of a model portfolio. Aggressive investors can load their portfolios with more volatile investments like equities and commodities. Investors with a more conservative outlook can assign greater weight age to relatively stable instruments like bonds and money market assets.
- The only certainty in financial markets is that it is impossible to consistently forecast the winners and the losers. Keeping that in mind, the prudent approach is to create a basket of investments within a given asset class so that the risk remains spread. Since it is difficult to predict which particular subset within an asset class is likely to outperform, diversification allows an investor to capture the returns but with far less volatility. If, for example, an investor wants to include equities in his portfolio, splitting up his investments across the different sectors of the economy, will result in a much more balanced portfolio.
- It involves the periodic buying and selling of assets so that a portfolio returns to its original target allocation at regular intervals. By periodically rebalancing, investors can decrease the likelihood of “portfolio drift,” thus potentially retaining the asset mix that best reflects their risk-return profile. For example, a portfolio that starts out with 50% equity and 50% fixed-income mix could, through a prolonged stock market rally, shift to an 80/20 allocation, thereby exposing the investor to greater risk. Selling the stocks that have considerably run-up and re-investing the proceeds in bonds will help in returning to the asset mix originally created. The optimal frequency to rebalance a portfolio depends on an investor’s transaction costs and whether the capital gains or losses incurred will be taxed at a short-term or a long-term rate. Generally, about once a year is adequate.
Stages in Portfolio Management
There are 5 broad stages in constructing a portfolio –
Identification of Objectives
- The first step in portfolio management process is the identification of the objectives and constraints of an investor. Different investors have different portfolio goals. Someone is his early 20s is more than likely to seek maximum capital appreciation, and will also be willing to expose himself to greater risk. Contrast that with someone who is on the verge of retiring from work. His or her risk appetite will be much lower, and his primary target would be to generate a stable income stream from his portfolio. The relative importance of each of these objectives should be clearly determined before a portfolio can be designed.
Selection of Asset Mix
- As has been stated above, proper asset allocation can be the sole differentiating factor between a good and an average portfolio. In this stage, the relationship between the various investable instruments has to be clearly defined. A portfolio may contain a mix of shares, bonds, ETFs, commodities, real estate etc. The percentage of each will depend on the risk tolerance and return expectation of the investor.
Formulation of Strategy
- After short listing the assets to be included in a portfolio, an investor has to formulate an appropriate strategy. There are two types of portfolio management strategies, active portfolio strategy and passive portfolio strategy, both of which are detailed later in the lesson.
- The selection of individual assets in a portfolio so that the returns potential is maximized can be performed either through fundamental analysis or technical analysis. Fundamental analysis is defined as the method of interpreting the intrinsic value of a security by evaluating related economic, financial and other quantitative factors. Technical analysis, on the other hand, is the system of forecasting the direction of asset prices by examining past market data, primarily price and volume.
- Once the buying and selling of specified securities that are selected for a portfolio is complete, periodically reviewing their performance is important to adjust for changing market conditions. Reviewing a portfolio may include adding or removing assets or altering their relative weight age to better reflect the investor’s risk-reward profile.
Efficient Portfolio Management
- The volatility in a portfolio can be limited by spreading the risk among the different asset classes. In fact, according to Harry Markowitz’s Nobel Prize winning “Modern Portfolio Theory,” an investor can actually decrease his portfolio’s overall risk by putting together a basket of diverse volatile stocks. Diversification depends less on the number of securities and more on how the securities perform relative to each other. Markowitz compared a portfolio comprising 60 railroad stocks with another portfolio of similar size that included utilities, railroads, mining, and manufacturing stocks. He concluded that the latter portfolio was better diversified because firms within the same industry group were more likely “to do poorly at the same time than firms in dissimilar industries.”
Portfolio Management Techniques
- Active Portfolio Strategy – In this, an investor resorts to market timing and switching from one asset class to another depending on the underlying economic conditions to earn a superior risk-adjusted return. Ideally, in active management, an investor tries to exploit market inefficiencies by buying assets that are undervalued and short selling securities that are overvalued.
Asset Allocation Strategies
- Strategic Asset Allocation – Strategic asset allocation is a portfolio strategy in which the asset mix is fixed according to the investor’s profile. The target allocation depend on factors such as the investor’s time horizon, risk tolerance and investment objectives. A popular asset mix is 60% equities, 30% bonds and 10% cash.
Despite the obvious importance of portfolio management, many investors have difficulty implementing an effective strategy to align their portfolios with their financial goals and to manage their investments in the long term. The key lies in clearly defining the objectives, sticking to a plan and keeping the process simple by not making the asset index too large.
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