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What is 'Portfolio Management'

Portfolio management is the art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against performance. Portfolio management is all about determining strengths, weaknesses, opportunities and threats in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and many other trade-offs encountered in the attempt to maximize return at a given appetite for risk.

BREAKING DOWN 'Portfolio Management'

In the case of mutual and exchange-traded funds (ETFs), there are two forms of portfolio management: passive and active. Passive management simply tracks a market index, commonly referred to as indexing or index investing. Active management involves a single manager, co-managers or a team of managers who attempt to beat the market return by actively managing a fund's portfolio through investment decisions based on research and decisions on individual holdings. Closed-end funds are generally actively managed.

The Key Elements of Portfolio Management

Asset Allocation: The key to effective portfolio management is the long-term mix of assets. Asset allocation is based on the understanding that different types of assets do not move in concert, and some are more volatile than others. Asset allocation seeks to optimize the risk/return profile of an investor by investing in a mix of assets that have low correlation to each other. Investors with a more aggressive profile can weight their portfolio toward more volatile investments. Investors with a more conservative profile can weight their portfolio toward more stable investments.

Diversification: The only certainty in investing is it is impossible to consistently predict the winners and losers, so the prudent approach is to create a basket of investments that provide broad exposure within an asset class. Diversification is the spreading of risk and reward within an asset class. Because it is difficult to know which particular subset of an asset class or sector is likely to outperform another, diversification seeks to capture the returns of all of the sectors over time but with less volatility at any one time. Proper diversification takes place across different classes of securities, sectors of the economy and geographical regions.

Rebalancing: This is a method used to return a portfolio to its original target allocation at annual intervals. It is important for retaining the asset mix that best reflects an investor’s risk/return profile. Otherwise, the movements of the markets could expose the portfolio to greater risk or reduced return opportunities. For example, a portfolio that starts out with a 70% equity and 30% fixed-income allocation could, through an extended market rally, shift to an 80/20 allocation that exposes the portfolio to more risk than the investor can tolerate. Rebalancing almost always entails the sale of high-priced/low-value securities and the redeployment of the proceeds into low-priced/high-value or out-of-favor securities. The annual iteration of rebalancing enables investors to capture gains and expand the opportunity for growth in high potential sectors while keeping the portfolio aligned with the investor’s risk/return profile.

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RELATED FAQS
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  3. Why is risk return tradeoff important in designing a portfolio?

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