WHAT IS A PORTFOLIO?
A collection of one or more similar or different investment vehicles.
WHAT IS PORTFOLIO MANAGEMENT?
It is the art and science of making investment decisions of mix and policy, asset allocation, balancing risk and performance, and matching investments to objectives.
THE FOUR MAIN TYPES OF PORTFOLIO MANAGEMENT
- Active Portfolio Management: hands-on approach with investing. PM’s charge percentage for AUM (Assets Under Management). The goal is to outperform some market benchmark usually characterized by an index.
- Passive Portfolio Management: involves selecting a group of investment vehicles that usually only track and index. The goal is to mirror the returns of the market over time. Use Modern Portfolio Theory (MPT) to optimize the mix.
- Discretionary Portfolio Management: Full control is given to PM to decide what to do with the investors cash
- Non discretionary Portfolio Management: reduces a PM’s job to that of a financial advisor.
THE THREE MAIN ELEMENTS OF PORTFOLIO MANAGEMENT
- Asset Allocation
- Diversification: spreading risk and reward within an asset class. Made across various asset classes.
- Rebalancing: Used to return a portfolio at regular intervals to its original target allocation. Used to help maintain the original asset mix.
CHARACTERISTICS OF INVESTMENTS
- Return: Expectation of return
- Risk: Examples; loss of capital, delay in repayments, non payment of return, variability in repayment, and defaults. The higher risk the higher the expected return.
- Security: certainty of return of (initial) capital without loss of time or money
- Liquidity: how easily an investment can be sold
One primarily wants: High returns (more specifically yield which is the net returns), low risk, safe & secure funds, and high liquidity.
Secondarily one also wants: Tax minimization, hedging against inflation
TWO KINDS OF ASSETS
- Real (physical) Assets: Non-divisible. Tangible. eg. Real estate, gold silver and other metals, consumer durables
- Financial Assets: Divisible. Piece of paper. eg. equity, fixed income (debt), credits, and derivatives
FINANCIAL ASSETS ARE FURTHER CLASSIFIED INTO:
- Marketable: You buy and do not know or care who the seller is. eg. Shares, bonds, Government securities, Mutual funds,
- Non marketable: are transacted between investor and issuer only. eg. Post office deposits, Company deposits, provident fund deposits, bank deposits
THREE KINDS OF INVESTORS
- Conservative: Invest in cash, TB, CD’s, Low risk investments
- Moderate: Invest in cash, bonds, long term stocks, low risk real estate. Low risk investments
- Aggressive: Invest mostly in the stock market and on high risk real estate. High risk investments
The kind of investor ultimately holds the level of risk tolerance they each possess.
THE 12 TYPES OF RISKS:
- Economic risk: danger of the economy as a whole performing poorly
- Industry risk: danger of a specific industry performing poorly. Also can crossover to other industries
- Tax risk: rising taxes will make investments less attractive as they affect capital gains, dividends, and interest
- Political risk: government legislation can have an adverse effect on an investment
- Reinvestment risk: risk subject to dividend reinvestment plans. Danger of yielding lower returns than prior to reinvestment
- Exchange rate risk: danger of a nation’s currency losing value when exchanged for foreign currencies
- Inflation rate risk: when inflation rises, investments have less purchasing power
- Liquidity risk: no volume in the investment you are trying to sell which may lead to a loss in value
- Market risk: chance of the entire market to decline
- Management risk: danger of a management team that will run a company poorly causing it not to grow or delay or not to payout dividends.
- Tenure risk: danger of losing money whilst holding on to a security
- Timing risk: danger of buying the right security at the wrong time or selling the security at the wrong time.
PORTFOLIO MANAGEMENT PROCESS:
- Set investment policy: define return objectives, risk objectives, asset allocation, guidelines for adjustments and rebalancing
- Analysis and evaluation of investment vehicles: select the investment vehicles that provide the best balance of diversification at a low cost
- Formation of diversified investments portfolio: using the Modern Portfolio Theory create portfolios matched to a range of risk tolerances
- Portfolio revision: understanding the risk preferences to finally agree on the suggested portfolio
- Measurement and evaluation of portfolio performance: monitor and rebalance portfolio to make sure it stays on track
ANALYSIS AND EVALUATION OF INVESTMENT VEHICLES
EXAMPLE OF ASSET ALLOCATION
It is the process of establishing the weights of asset classes in a total portfolio.
Inherently contains the conscious effort to gain exposure to the desired level of risk.
Putting in mind capital market expectations, risk and return, and objectives and constraints.
There are many methods and strategies for portfolio building. Portfolio management is an important subject and requires a much deeper understanding. In this post I tried to simplify many concepts and condense them and present them in an informative way. I will be exploring this topic much more thoroughly focusing on the literature and the quantitative side of portfolio theory. It will be very interesting to learn what strategies work for which investment vehicles and how they work.