Meaning of Portfolio
Portfolio Management is simply combinations of different securities. It is the basket or collection of different types of securities that the investor maintains.
In other words, Portfolio is a combination of securities such as stocks, bonds, gold, currencies and money market instruments. It is often convenient to think of a person owning several “portfolios,” but in reality he has only one portfolio, the one that comprises everything he own.
The characteristics of investments do differ when we possess them in portfolio management. As it is the combination of different securities and the investor should keep different types of securities in his portfolio making his portfolio as diversified portfolio. Because, diversification of investments helps to spread risk over many securities. A diversification of securities gives the assurance of obtaining the anticipated return on the portfolio. In a diversified portfolio, some securities may not perform as expected, but others may exceed the expectation and making the actual return of the portfolio reasonably close to the anticipated one.
Keeping the single security in the portfolio may lead to greater likelihood of variance in the expected return and actual return or the chances of loss are more if the security fails. Hence, it is a common practice to diversify securities in the portfolio
Meaning of Portfolio Management
Portfolio management is also called as investment management. Simply, it is the process of managing the portfolio.
In other words, in portfolio management, the investor manages his securities in the portfolio. It means, it is the process which starts from the creation of portfolio and ends with the performance evaluation of securities. It involves the process of selection & rejection of securities, to be considered in the portfolio, portfolio execution & revision as well. This process may be divided into seven steps:
- Investment Objectives and Constraints.
- Choice of Asset mix.
- Formulation of Portfolio strategy.
- Selection of Securities.
- Portfolio Execution.
- Portfolio Revision.
- Performance Evaluation.
Investment Objectives and Constraints
The first step in the portfolio management process is to specify the investment policy which contains the objectives, constraints, and preferences of the investor. The investment policy may be expressed as:
The commonly stated investment goals are:
- Income→ To have a fixed income through regular interest/dividend payment.
- Growth→ To increase the value of the principal amount through capital appreciation.
To pursue investment objective, the constraints have to be taken into account like:
- Liquidity→ It refers to the speed with which an asset can be sold, without suffering any discount to its fair market price. Like, money market instruments are most liquid assets, while bonds, antiques, precious metals are least liquid
- Investment Horizon→ The investment horizon is the time when the investment or part thereof is planned to be liquidated to meet a specific need. For example, the investment horizon may be ten years to fund a child’s education or thirty years to meet retirement needs.
The post tax return from an investment finally matters. Therefore, Tax considerations have an important bearing on investment decisions. So, tax provisions should be reviewed carefully and the same should be incorporated in the investment decisions.
Choice of Asset Mix
Based on the above objectives and constraints, asset allocation should be specified. It means one has to decide how much of his portfolio has to be invested in each of the following asset categories:
- Real Estate
- Precious Metals.
Formulation of Portfolio Strategy
After selecting the certain asset mix, an appropriate portfolio strategy has to be formulated. The two appropriate portfolio strategy are:
Passive Management→ It is the process of holding a well diversified portfolio for a long term with the buy and hold approach. It refers to the investor’s attempt to construct a portfolio that resembles the overall market returns. It means holding the index fund which is designed to replicate a good and well defined index of the common stock. The person purchases every stock in the index in exact proportion of the stock in that index. If Wipro’s stock constitutes 5% of the index, the person also invests 5% of its money in Wipro stock.
Active Management→ It is holding securities based on the forecast about the future. The portfolio managers who pursue active strategy with respect to market components are called “market timers”. The managers may indulge in ‘group rotations’. Here, the group rotation means changing the investment in different industries’ stocks depending on the assessed expectations regarding their future performance. Stock that seem to be best bets or attractive are given more weights in the portfolio that their weights in the index. Also, stocks that are considered to be less attractive are given lower weights compared to their weights in the index.
Selection of Securities→
It includes the selection of following:
- Selection of Bonds→ Following factors are taken into consideration while selecting the fixed income avenues:
- Yield to Maturity→ The yield to maturity for a fixed income avenue represents the fixed rate of return earned by the investor, if he invests in the fixed income avenue and holds it till its maturity.
- Risk of Default→ To assess the risk of default on a bond, the credit rating of the bond may be looked up. If no credit rating is available, examine relevant financial ratios (like debt equity ratio, times earned ration, and earning power) of the firm and assess the general prospects of the industry to which the firm belongs.
- Liquidity→ If the fixed income avenue can be converted wholly or substantially into cash at a fairly short notice, it possesses liquidity of a high order.
- Tax shield→ Several fixed income avenues offered tax shield also. In previous years, many bonds were providing tax shield, now very few do so.
- Selection of Stocks (Equity Shares)→ Three broad approaches are employed for the selection of equity shares – Technical analysis, Fundamental analysis, and random selection. Technical analysis looks at price behaviour and volume data to determine whether the prices of share will move up or down or remain trend less. Fundamental analysis focuses on fundamental factors like the earnings level, growth prospects, and risk exposure of the company to establish the intrinsic value of a share. The recommendation to buy, hold, or sell is based on a comparison of the intrinsic value and the prevailing market price. The random selection approach is based on the ground that the market is efficient and securities are properly priced.
Portfolio Execution→ Up to this phase of portfolio management, several key issues have been sorted out. Investment objectives and constraints have been specified, asset mix has been chosen, portfolio strategy has been developed, and specific securities to be included in the portfolio have been identified. The next step is to implement the portfolio plan by purchasing and/or selling specified securities in given amounts. This is the phase of portfolio management. It is an important practical step that has a significant bearing on investment results. Further, it is neither simple nor costless as it is sometimes honestly felt.
Portfolio Revision→ The value of a portfolio as well as its composition – the relative proportions of stock and bond components – may change as stocks and bonds fluctuate. Generally, the fluctuation in stocks is often the dominant factor underlying this change. In response to such changes, periodic rebalancing of the portfolio is required. This primarily involves a shift from stocks to bonds or vice-versa. In addition, it may call for sector rotation as well as security switches.
Performance Evaluation→ The performance of a portfolio should be evaluated periodically. The key dimensions of portfolio performance evaluation are risk and return and the key issue is whether the portfolio return is matching with its risk exposures. Such a review may provide useful feedback to improve the quality of the portfolio management process on a continuing basis.
Performance Evaluation of Existing Portfolio
Portfolio performance evaluation is a component of the portfolio management process. The portfolio manager evaluates his portfolio performance and identifies the sources of strength and weakness. The evaluation of the portfolio provides a feedback about the performance to evolve better management strategy. Basically, it can be viewed as a feedback and control mechanism that identifies superior performance and makes the investment management process successful. Superior performance of a portfolio may have been the result of good portfolio management decisions or due to chance. Conversely, inferior performance of a portfolio could also be attributed to a chance factor or due to costs associated with unscientific portfolio management.
Portfolio performance is evaluated over a specific time period. The most often used risk adjusted portfolio performance measures are the:
- Sharpe Portfolio Performance Measure.
- Treynor Portfolio Performance Measure.
- Jensen Portfolio Performance Measure.
Sharpe Portfolio Performance Measure
The Sharpe ratio is a reward-to-risk ratio that focuses on total risk. One simple way to investigate the fund’s performance is to consider risk-adjusted returns. The returns from a portfolio are initially adjusted for risk free return. These excess returns attributable as reward for investing in Risky assets are validated in terms of return per unit of risk. Thus, the Sharpe measure gives us a measure of return per unit of total risk.
Rp – Average rate of return on portfolio p.
Rf – Average rate of return on a risk-free investment.
sp – Standard Deviation of return of portfolio p.
Hence, the Sharpe measure reflects the excess return earned on a portfolio per unit of its total risk (standard deviation).
The higher the Sharpe measure, the better the performance.
Fig: Graphical Representation of the Sharpe Ratio