Portfolio management involves deciding what assets to include in the portfolio, given the goals of the portfolio owner and changing economic conditions. Selection involves deciding what assets to purchase, how many assets to purchase, when to purchase them, and what assets to divest. These decisions always involve some sort of performance measurement, most typically expected return on the portfolio, and the risk associated with this return (i.e. the standard deviation of the return). Typically the expected return from portfolios of different asset bundles is compared.
In finance, a portfolio is an appropriate mix of or collection of investments held by an institution or a private individual.
Holding a portfolio is part of an investment and risk-limiting strategy called diversification. By owning several assets, certain types of risk (in particular specific risk) can be reduced. The assets in the portfolio could include stocks, bonds, options, warrants, gold certificates, real estate, futures contracts, production facilities, or any other item that is expected to retain its value.
In building up an investment portfolio a financial institution will typically conduct its own investment analysis, whilst a private individual may make use of the services of a financial advisor or a financial institution which offers portfolio management services.
The unique goals and circumstances of the investor must also be considered. Some investors are more risk averse than others.
Portfolio Management Basics
Selection of Asset Mix
Depending on your objectives and limitations, you must come up with your asset allocation plan, i.e. you have to decide how much investment of your portfolio should be done in each of the following asset types:
- Real estate
- Precious metals
Our discussion will basically center on determining a suitable blend of bonds and stocks in the portfolio. Before we proceed ahead with this point, the following points should be noted:
Portfolio Management Principles
1. For most individuals, the first crucial investment decision is related to their education intended for building their human capital.
2. The most important asset that people normally possess during their early working years is their earning strength that arises from their human capital. Buying the life and disability insurance becomes the need of the hour to safeguard against the possible loss of income due to disability or even death.
3. The first and foremost economic asset that individuals plan to invest in is a house of their own. Their savings are expected to be in the form of money market mutual fund schemes and bank deposits, before they are ready to purchase a house. These instruments are broadly referred to as cash and are alluring due to their safety and liquidity.
4. Once the portfolio is invested in house, and rational liquidity in terms of cash is retained to cater to the expected as well as unexpected expenses, then the spotlight moves on to planning for children’s education, providing financial support to the family, making provisions for retirement, and indulging into charitable activities. Stocks and Bonds become very crucial in this context. We define them broadly as:
Stocks include equity shares (which in turn may be categorized into growth shares, income shares, cyclical shares, blue-chip shares, speculative shares etc) and shares or units of equity schemes of mutual funds (like Fidelity, Mastershares etc).
Bonds include non-convertible debentures of private sector companies, public sector bonds, gilt-edged securities, National Savings Certificate, post office savings deposits, bank deposits, deposits in provident fund and public provident fund schemes etc.
The fundamental feature of these investments is that they give fixed or near-fixed returns.
What should be the long-term stock-bond mixture? Should it be 50:50 or 25:75 or 75:25 or anything else? This decision is the most crucial decision taken by an investor and is referred to as the strategic asset-mixdecision or policy asset-mix decision. Experimental study has reveled that almost 90 percent of the variation of the returns of portfolio is justified by its asset mix. In other words, only 10 percent of the variation of the portfolio return is enlightened by other factors like ‘security selection’ and ‘sector rotation’. Given the importance of a good asset-mix, you should knock it down carefully.
The Fallacy of Time Diversification
It is claimed by Paul Samuelson and others that the concept of time diversification is untrue. Although the ambiguity related to average rate of return fades away over a long time period, it also multiplies over a longer period of time. The latter effect unfortunately takes over. Thus, as the investment horizon lengthens, the total return becomes more and more ambiguous.
Resurrection of Time Diversification
There are few very justifiable reasons as to why you should still shape up your risk posture on your investment horizon. The two important reasons amongst them are:
1. There is some proof that returns on stock are not successively independent but are inclined to mean-revert over long intervals of time. In short, there is a high possibility of a below-average return be followed by above-average return than again by yet another below-average return. Considering this trend of stock returns to mean-revert, the spreading of terminal wealth advances at a slower return than what is indicated by successively independent returns. (Note that it is assumed by the critics of time diversification that stock returns are successively independent in a seamlessly proficient market.)
2. You may tend to take more risks in longer horizon as you may have more scope to amend your work habits and consumption.
It is well said by Mark Kritzman:
“If a risky investment performs poorly at the beginning of a short horizon, there is little you can do to compensate for loss of wealth. Over a long horizon, however, you can postpone consumption, and work harder to achieve your financial goals.”
P.S. This is a first article in the series “How to get into Portfolio Management”. Going forward, I will focus on different careers in finance and how to get into each one of these. I welcome your feedback and suggestions.
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