Portfolio Management Process

PORTFOLIO:

Portfolio is the combination of securities such as stocks, bonds and money market instruments. Investment portfolio is the set of investment vehicles, formed by the investor seeking to realize its’ defined investment objectives. In other words, Portfolio - an appropriate mix of or collection of investments held by an institution or a private individual. The process of blending together the broad asset classes so as to obtain optimum return with minimum risk is called portfolio construction. Diversification of investments helps to spread risk over many assets.

Portfolio management:

Portfolio Management - 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 vs. performance. Portfolio Management Involves,-Investing and divesting different, -investment Risk management,- Monitoring and analyzing returns

Portfolio management is a process encompassing many activities aimed at optimizing the investment of one’s funds.

Objective of make portfolio:

The portfolio construction and management can satisfy the following objectives:

WHY PORTFOLIO:

1)      Performance measurement

2)      Improvement – learning loop

3)      Discipline

4)      Risk control

5)      Consistency

6)      Continuity

7)      Selling tool,

The objectives of portfolio management is to maximize the return and minimize the risk. These objectives are categorized into:

Basic Objectives §       Maximize yield, §       Minimize risk.

Subsidiary Objectives §       Reasonable income on investment §       Appreciation of capital §       Safety of the investment and liquidity §       Termination and marketable facility

Scope of portfolio management:
portfolio management is a continues process. It is a dynamic activity. The following are the basic operation of a portfolio management:

1.      Monitoring the performance of portfolio by incorporating the latest market conditions.

2.      Identification of the investor’s objectives, constraints and preferences.

3.      Making an evaluation of portfolio income (comparison with targets and achievement).

4.      Making revision in the portfolio.

5.      Implementation of the strategies in tune with investment objectives.

Nature of Portfolio Management:

1.      Portfolio should be constructed according to the investor’s objectives.

2.      Constructed portfolio shall be reviewed from time to time in view of latest market developments.

3.      The portfolio evaluation should be done according to risk and return.

4.      Portfolio management is a dynamic concept.

5.      It involves a regular, scientific analysis, right judgment and timely action.

Importance/ Benefits of Portfolio:

ü  It helps to spread risk over many assets.

ü  It gives the assurance of obtaining the anticipated return on the portfolio.

ü  It helps in improving the return through time to time control and portfolio revision.

ü  It helps in risk control.

Phases of Portfolio Management:

Portfolio management is a process encompassing many activities aimed at optimizing the investment of one’s funds. Five phases can be identified as this process:-
1. Security analysis
2. Portfolio Analysis
3. Portfolio Selection
4. Portfolio revision
5. Portfolio Evaluation

Portfolio construction process:

The diagram shows the process of portfolio construction:

Approaches in portfolio construction:

Commonly, there are two approaches in the construction of the portfolio of securities viz, traditional approach and Markowitz efficient frontier approach.

In the tradition approach, investor’s needs in terms of income and capital appreciation are evaluated and appropriate securities are selected to meet the needs of the investor.  In the modern approach, portfolios are constructed to maximize the expected return for a given level of risk. It views portfolio construction in terms of the expected return and the risk associated with obtaining the expected return.

Tradition Approach:

The traditional approach basically deals with two major decisions. They are:

1)      Determining the objectives of the portfolio

2)      Selection of securities to be included in the portfolio.

Normally, this is carried out in four to six steps:

1.      Analysis of Constraints:

The constraints normally discussed are: income needs, liquidity, time horizon, safety, tax consideration and the temperament.

a)      Income Needs: the income needs depend on the need for income in constant rupees and current rupees. The need for income in current rupees arises from the investor’s need to meet all or part of the living expenses. At the same time inflation may erode the purchasing power, the investor may like to offset the effect of the inflation and so, needs income in constant rupees.

v  Need for current income: the investor should establish the income which the portfolio should generate. The current income need depends upon the entire current financial plan of the investor. The expenditure required to maintain a certain level of standard of living and all the other income generating sources should be determined. Once this info. Is arrived at, it is possible to decide how much income must be provided for the portfolio of securities.

v  Need for constant income: funds should be invested in such securities where income from them might increase at a rate that would offset the effect of inflation. The inflation or purchasing power risk must be recognized but this does not pose a serious constraint on portfolio if growth stocks are selected.

b)     Liquidity: if the investor prefer to high liquidity, then funds should be invested in high quality short term debt maturity issues such as money market funds, commercial papers and shares that are widely traded. Keeping the funds in shares that are poorly traded or stocks in closely held business and real estate lack liquidity. The investor should plan his cash drain and the need for net cash inflows during the investment period.

c)      Safety of the principal: investing in bonds and debentures is safer than investing in the stocks. Even among the stocks, the money should be invested in regularly traded companies of longstanding. Investing money in the unregistered finance companies may not provide adequate safety.

d)     Time horizon: is the investment planning period of the individuals. This varies from individual to individual. The first stage is the early career stage; at this stage his assets are lesser than their liabilities. His priority towards investments may be in the form of savings for liquidity purposes. The investor is young at this stage and has long horizon of life expectancy with possibilities of growth in income, he can invest in high-risk and growth oriented investments.

The other stage of the time horizon is the mid career individual. At this stage, his assets are larger than his liabilities. He may wish to reduce the overall risk exposure of the portfolio but, he may continue to invest in high risk and high return securities. The final stage is the late career or the retirement stage. In this stage, he shifts his investment to low return and low risk category investment.

e)      Tax consideration: investors in the income tax paying group consider the tax concessions they could get from their investment.

f)       Temperament: Some investors are risk lovers or takers who would like to take up higher risk even for low return. While some investors are risk averse, who may not be willing to undertake higher level of risk even for higher level of return. The risk neutral investors match the return and the risk. Hence, the temperament of the investor plays an important role in setting the objectives.

2.      Determination of objectives:  portfolios have the common objectives:

ü  Current income

ü  Growth in income

ü  Capital appreciation

ü  Preservation of capital

3.      Selection of portfolio: the selection of portfolio depends on the various obejectives of the investors.

v  Objectives and asset mix: if the main objective if getting adequate amount of current income, sixty per cent of the investment is made on debts and forty per cent on equities. The proportions of investment on debts and equity differ according to the individual’s preferences.

v  Growth of income and asset mix: the investor’s portfolio may consist of 60 to 100 % equities and 0 to 40 % debt instrument.

v  Capital appreciation and asset mix: for this the investor’s portfolio may consist of 90 to 100 % equities and 0-10% of debts.

v  Safety of principal and asset mix:  the investor’s portfolio may consist more of debt instruments and within the debt portfolio more would be on short term debts.

4.      Risk and return analysis: the traditional approach to portfolio building has some basic assumptions. First, the individual prefers larger to smaller returns from securities. To achieve this goal, the investor has to take more risk. The ability to achieve higher returns is dependent upon his ability to judge risk and his ability to take specific risks. The investors make a series of compromises on risk and non-risk factors like taxation and marketability after he has assessed the major risk categories, which he is trying or minimize.

5.      Diversification:  according to the investor’s need for income and risk tolerance level portfolio is diversified. In the stock portfolio, he has to adopt the following steps which are shown in the following figure:

Assumptions:

The traditional theory is based on the following assumptions:

1.      It assumes that the market is inefficient.

2.      It also thinks that the fundamentalists can take advantage of market inefficiency situation.

3.      It felt that the fundamentalists can earn quick profits.

4.      It considers that the fundamentalists will expect the potential growth of a particular company for predicting the future trend of the share prices.

Modern approach:

In the modern approach Markowitz model is used. Markowitz gives more attention to the process of selecting the portfolio. His planning can be applied more in the selection of common stocks portfolio than the bond portfolio. The stocks are not selected on the basis of need for income or appreciation but the selection is based on the risk and return analysis. This approach follows the following steps:

From the list of stocks quoted at the Bombay Stock Exchange or at any other regional stock exchange, the investor selects roughly some group of shares. For these stocks expected return and risk would be calculated. The investor is assumed to have the objectives of maximizing the expected return and minimizing the risk. Further, it is assumed that investors would take up risk in a situation when adequately rewarded for it. This implies that individuals would prefer the portfolio of highest expected return for a given level of risk. The final step is asset allocation process that is to choose the portfolio that meets the requirements of the investor. The risk taker would choose high risk portfolio. Investor with lower tolerance for risk would choose low level risk portfolio. The risk neutral investor would choose the medium level risk portfolio.

Assumptions:

Modern portfolio theory is based on the following assumptions:

1.      It is based on assumption of free and perfect flow of information.

2.      It believes that markets are perfect and absorbs all information quickly.

3.      The riskiness of a financial asset in portfolio is to be seen in the context of market related risk or portfolio risk, but not in isolation.

It also indicates that the returns are the same whenever you enter the market. This theory uses  of Beta for measuring the market risk.

The difference between Traditional Portfolio Theory and Modern Portfolio Theory.

Traditional Portfolio Theory	Modern Portfolio Theory
§       It deals with the evaluation of return and risk conditions in each security. §       It is based on measurement of standard deviation of particular scrip. §       It assumes that market is inefficient. §       It gives more importance to standard deviation.	§       It deals with the maximization of returns through a combination of different types of financial assets. §       It is based on mainly diversification process. §       It assumes that market is perfect and all information is known to public. §       It gives more importance to Beta.

The following are some of the important Modern Portfolio theories:

1.      Markowitz Theory of Portfolio Management.

2.      Sharpe’s Theory of Portfolio Management.

3.      Capital Asset Pricing Model.

Managing the Portfolio:

There are two approaches to manage the portfolio:

1.      Passive Approach: in the passive approach the investor would maintain the percentage allocation for asset classes and keep the security holdings within its place over the establishes holding period.

2.      Active Approach: in this the investors continuously assess the risk and return of the securities within the asset classes and changes them accordingly.