This is second post in the series how to get into portfolio management.
In this post we will cover concepts Portfolio Revision, Portfolio Upgrading and Portfolio Rebalancing.
Portfolio Management Concepts
No matter how perfectly you have built your portfolio, it eventually becomes inefficient and so needs to be checked and updated periodically.
According to Robert D Arnott:
“Portfolios do not match themselves. Nor can weather the ages unaltered. With each passing day, portfolios that we carefully crafted yesterday become very less-than-optimal. Change is the investor’s only constant.”
Several things are likely to transpire over time. To name a few, the asset mix in the portfolio may have gone away from its target, the risk and return features of different securities may have amended, last but not the least, the motives and preferences itself of the investor might have changed over the course of time.
Taking into account the dynamic changes in the capital market as well as in your circumstances, you should keep an eye and alter your portfolio on periodic basis which typically involves two things: portfolio upgrading and portfolio rebalancing.
Portfolio upgrading involves re-evaluating the risk-return features of several securities (both stocks and bonds), buying under-priced securities and selling over-priced securities. It may also include other adjustments that the investor might think are essential for improving the performance of the portfolio.
You may be hesitant to alter your portfolio or even may be too slow in doing so. You may dislike facing the trading costs like taxes, commission costs and undesirable market impacts. Often these costs appear to be obvious. However, note that there are also non-trading costs which may seem restrained but can be quite significant. Your portfolio may move to an asset mix that may no longer be suitable for your requirements; you may possess over-priced investments that offer very less returns; you may miss opportunities of making assuring investments. You should understand how to balance the non-trading opportunity cost against the explicit trading costs. Portfolio revision essentially calls for building an appropriate response to the tension prevailing between the obvious cost of trading and the restrained cost of inaction.
Portfolio rebalancing includes reviewing and amending the composition of portfolio i.e. the stock-bond mix. The three fundamental policies pertaining to portfolio rebalancing are: buy and hold policy, constant mix policy and portfolio insurance policy.
The original portfolio is left untouched under the buy and hold policy. It is literally a ‘buy and hold policy’ which means that no matter what happens to relative values, no amendments are done. For instance, if the original portfolio has a stock-bond mix of say 60:40 which after few months becomes say 80:20 due to appreciation of stock component and stagnancy of bond component, the portfolio mix is allowed to drift i.e. no changes are made.
The constant mix policy involves keeping up the stock and bond proportions in line with their target value. For instance, the preferred mix of stocks and bonds is say, 60:40, and then the constant mix involves adjusting the portfolio when the relative values of the components change so that the intended proportions are maintained.
The portfolio insurance policy includes raising the exposure to stocks if the portfolio appreciates in value and decreasing the exposure to stock if the portfolio depreciates in value. The key principal is to make sure that the value of the portfolio does not drop below a floor level.
This was the second post in the portfolio management category.
Image Credit: Kozzi.com