A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, as well as their mutual fund, exchange-traded fund and closed-fund counterparts. Portfolios are held directly by investors or managed by financial professionals.
Investors should construct an investment portfolio in accordance with their risk tolerance and investing objectives. Think of an investment portfolio as a pie that is divided into pieces of varying sizes representing different asset classes and/or types of investments to accomplish an appropriate risk-return portfolio allocation.
A conservative investor might favor a portfolio with large cap value stocks, broad-based market index funds, investment-grade bonds and a position in liquid, high-grade cash equivalents. In contrast, a risk-loving investor might add some small cap growth stocks to an aggressive, large cap growth stock position, assume some high-yield bond exposure, and look to real estate, international and alternative investment opportunities for his or her portfolio.
A common way to evaluate portfolio returns is to compare them to a benchmark, such as an index. These are the most common benchmarks:
- Standard & Poor's 500 - for large-cap stocks
- Russell 2000 - for small-cap stocks
- Europe, Australia and Far East Index (EAFE) - for international stocks
Portfolio weight is the percentage composition of a particular holding in a portfolio. Portfolio weights can be calculated using different approaches; the most basic type of weight is determined by dividing the dollar value of a security by the total dollar value of the portfolio. Another approach is to divide the number of units of a given security by the total number of shares held in the portfolio.
Portfolio weights are not necessarily applied only to specific securities; investors can calculate the weights of their portfolios in terms of sector, geographical region, index exposure, short and long positions, type of security (such as bonds or small cap technology companies) or any other type of category. Essentially, portfolio weights are determined based on the particular investment strategy.
The Portfolio Management Process
The portfolio management process is the method an investor uses to aid him in meeting his investment goals.
The procedure is as follows:
- Create a Policy Statement – A policy statement is the statement that contains the investor's goals and constraints as they relate to his investments.
- Develop an Investment Strategy – This entails creating a strategy that combines the investor's goals and objectives with current financial market and economic conditions.
- Implement the Plan Created – This entails putting the investment strategy to work by investing in a portfolio that meets the client's goals and constraint requirements.
- Monitor and Update the Plan – Both markets and investors' needs change as time passes. As such, it is important to monitor for these changes as they occur and to update the plan to adjust accordingly.
A policy statement is the statement that contains the investor's goals and constraints as it relates to his investments. This step could be considered to be the most important of all the steps in the portfolio management process. The statement requires the investor to consider his true financial needs, both in the short run and the long run. It helps to guide the investment portfolio manager in meeting the investor's needs. When there is market uncertainty or the investor's needs change, the policy statement will help to guide the investor in making the necessary adjustments to the portfolio in a disciplined manner.
Expressing Investment Objectives in Terms of Risk and Return
Return objectives are important to determine. They help to focus an investor on meeting his financial goals and objectives. However, risk must be considered as well. An investor may require a high rate of return, which is typically accompanied by a higher risk. Despite the need for a high return, an investor may be uncomfortable with the risk that is attached to that higher-return portfolio. As such, it is important to consider not only return but also the investor's risk tolerance in a policy statement.
Factors Affecting Risk Tolerance
Many factors can affect an investor's risk tolerance:
- Age – An investor may have lower risk tolerance as they get older and financial constraints are more prevalent.
- Family situation – An investor may have higher income needs if they are supporting a child in college or an elderly relative.
- Wealth and income – An investor may have a greater ability to invest in a portfolio if he or she has existing wealth or high income.
- Psychological – An investor may simply have a lower tolerance for risk based on his personality.
Return Objectives and Investment Constraints
Return objectives can be divided into the following categories:
- Capital Preservation - Capital preservation is the need to maintain capital. To accomplish this objective, the return objective should, at a minimum, be equal to the inflation rate. In other words, the nominal rate of return would equal the inflation rate. With this objective, an investor simply wants to preserve his existing capital.
- Capital Appreciation - Capital appreciation is the need to grow, rather than simply preserve, capital. To accomplish this objective, the return objective should be equal to a return that exceeds the expected inflation rate. With this objective, an investor's intention is to grow his existing capital base.
- Current Income - Current income is the need to create income from the investor's capital base. This objective is common among retired investors who no longer have income from work and therefore need to generate income from their investments to meet living expenses and other spending needs.
- Total Return - Total return is the need to grow the capital base through both capital appreciation and reinvestment of that appreciation.
When creating a policy statement, it is important to consider an investor's constraints. There are five types of constraints that need to be considered when creating a policy statement:
- Liquidity Constraints - Liquidity constraints identify an investor's need for liquidity (or cash). For example, within the next year, an investor needs $50,000 for the purchase of a new home. The $50,000 would be considered a liquidity constraint because it needs to be set aside (be liquid) for the investor.
- Time Horizon - A time horizon constraint develops a timeline of an investor's various financial needs. The time horizon also affects an investor's ability to accept risk. If an investor has a long time horizon, the investor may have a greater ability to accept risk because he would have a longer time period to recoup any losses. This is unlike an investor with a shorter time horizon, such as an investor nearing retirement, whose ability to accept risk may be lower because he would not have the ability to recoup any losses.
- Tax Concerns - After-tax returns are the returns investors are focused on when creating an investment portfolio. If an investor is currently in a high tax bracket as a result of her income, it may be important to focus on investing more heavily in tax-deferred investments.
- Legal and Regulatory - Legal and regulatory factors can act as an investment constraint and must be considered. An example of this would occur in a trust. A trust could require that no more than 10% of the trust be distributed each year. Legal and regulatory constraints such as this one often can't be changed and must not be overlooked.
- Unique Circumstances - Any special needs or constraints not recognized in any of the constraints listed above would fall in this category. An example of a unique circumstance would be the constraint an investor might place on investing in any company they do not consider socially responsible, such as a tobacco company.
The Importance of Asset Allocation
Asset allocation is the process of dividing a portfolio among major asset categories such as bonds, stocks and cash. The purpose of asset allocation is to reduce risk by diversifying the portfolio.
The ideal asset allocation differs based on the risk tolerance of the investor. For example, a young executive might have an asset allocation of 80% equity, 20% fixed income, while a retiree would be more likely to have 80% in fixed income and 20% in equities.
Citizens in other countries around the world would have different asset allocation strategies depending on the types and risks of securities available for placement in their portfolios. For example, a retiree located in the United States would most likely have a large portion of his portfolio allocated to U.S. treasuries, since the U.S. government is considered to have an extremely low risk of default. On the other hand, a retiree in a country with political unrest would most likely have a large portion of their portfolio allocated to foreign treasury securities.
Portfolio Management Theories
Risk aversion is an investor's general desire to avoid risky investments. Investors typically wish to maximize their returns with the least amount of risk possible. When faced with two investment opportunities with similar returns, a good investor will always choose the investment with the least risk as there is no benefit to choosing a higher level of risk unless there is also an increased level of potential return.
Markowitz Portfolio Theory
Harry Markowitz developed this portfolio model. This model includes not only expected return, but also the level of risk for a particular return. Markowitz assumed the following about an individual's investment behavior:
- Given the same level of expected return, an investor will choose the investment with the lowest amount of risk.
- Investors measure risk in terms of an investment's variance or standard deviation.
- For each investment, the investor can quantify the investment's expected return and the probability of those returns over a specified time horizon.
- Investors seek to maximize their utility.
- Investors make decisions based on an investment's risk and return, therefore, an investor's utility curve is based on risk and return.
The Efficient Frontier
Markowitz's work on an individual's investment behavior is important not only when looking at individual investment, but also in the context of a portfolio. The risk of a portfolio takes into account each investment's risk and return as well as the investment's correlation with the other investments in the portfolio.
A portfolio is considered efficient if it gives the investor a higher expected return with the same or lower level of risk as compared to another investment. The efficient frontier is simply a plot of those efficient portfolios, as illustrated below.
While an efficient frontier illustrates each of the efficient portfolios relative to risk and return levels, each of the efficient portfolios may not be appropriate for every investor. Recall that when creating an investment policy, return and risk management are the key objectives. An investor's risk profile is illustrated with indifference curves. The optimal portfolio is the point on the efficient frontier that is tangential to the investor's highest indifference curve. (See our article, A Guide to Portfolio Construction, for some essential steps when taking a systematic approach to constructing a portfolio.)
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