16.2 Portfolio Management Process

The Portfolio Management Process

Although securities are sometimes selected on their own merits, portfolio management emphasizes the dynamics of securities within a broader context. This process is known as the portfolio approach. It considers the inter-relationships between various securities and their collective impact on the overall portfolio.

Key Concepts

• Return: The return of the portfolio is the weighted average of the returns of each security within it.
• Risk: The risk of a portfolio is generally lower than the risk of individual securities due to diversification.

The idea is that the interaction among securities results in a portfolio that has a superior risk-reward profile than its components considered independently. This is a fundamental advantage of the portfolio management approach.

Steps in Portfolio Management

The following are the fundamental steps in the portfolio management process:

1. Determine Investment Objectives and Constraints: Identify the goals and limitations pertinent to the investor, such as income requirements, time horizon, and risk tolerance.

2. Design an Investment Policy Statement (IPS): Document the client’s objectives, constraints, and the strategies to be employed in a formal IPS.

3. Develop the Asset Mix: Allocate assets among various asset classes (e.g., equities, bonds, cash) to achieve the desired balance of return and risk.

4. Select Securities: Choose specific securities to include in the portfolio based on analysis and valuation.

5. Monitor the Client, the Market, and the Economy: Continuously review the client’s situation, market trends, and economic conditions.

6. Evaluate Portfolio Performance: Assess the performance of the portfolio relative to the objectives and benchmarks.

7. Rebalance the Portfolio: Adjust the portfolio as necessary to realign with the prescribed investment strategy.

This process is iterative, as illustrated in Figure 16.1, with regular re-evaluations of investment objectives and constraints essential to align with evolving client needs.

Portfolio Management Cycle

    graph TD
	    A[Determine Investment Objectives and Constraints] --> B[Design an Investment Policy Statement]
	    B --> C[Develop the Asset Mix]
	    C --> D[Select Securities]
	    D --> E[Monitor Client, Market, and Economy]
	    E --> F[Evaluate Portfolio Performance]
	    F --> G[Rebalance the Portfolio]
	    G --> A

Frequently Asked Questions (FAQs)

Q1: Why is diversification important in portfolio management?

A: Diversification helps lower the overall risk of a portfolio by spreading investments across various asset classes and securities, reducing the impact of any single investment’s poor performance.

Q2: What is an Investment Policy Statement (IPS)?

A: An IPS is a formal document outlining an investor’s goals, constraints, and strategies to be followed for achieving these goals. It serves as a guideline for investment decisions.

Q3: How often should a portfolio be rebalanced?

A: The frequency of rebalancing depends on the investor’s objectives and market conditions. Typically, portfolios are rebalanced annually or semi-annually.

Mathematical Formulas

Portfolio Return

• \(R_p\): Portfolio return
• \(n\): Number of securities
• \(w_i\): Weight of each security
• \(R_i\): Return of each security

Portfolio Risk

The risk of a portfolio ((\sigma_p)) can be seen as:

• \(\sigma_p^2\): Variance of the portfolio
• \(w_i\), \(w_j\): Weights of securities
• \(\sigma_i\), \(\sigma_j\): Standard deviations of securities
• \(\rho_{ij}\): Correlation between securities

Key Takeaways

• Risk and Return: The portfolio approach generally aims to optimize risk and return by considering how different securities interact rather than focusing on individual performance.
• Continuous Process: Portfolio management is an ongoing cycle that requires periodic reassessment to align with changing financial goals and market conditions.
• Structure and Discipline: An Investment Policy Statement (IPS) provides a structured approach that aids in maintaining discipline in portfolio management.

Glossary

• Diversification: Strategy of spreading investments across various financial instruments to reduce risk.
• Investment Policy Statement (IPS): A formal document outlining an investor’s objectives, limitations, and strategies.
• Asset Mix: Distribution of investments across different asset classes.
• Rebalancing: Adjusting the portfolio to align with the desired asset allocation strategy.

By following these structured steps and maintaining disciplined oversight, financial professionals can better manage clients’ portfolios to meet their evolving investment goals.