UNDERSTANDING PORTFOLIO MANAGEMENT

When we say that we are taking a portfolio approach that means that we are evaluating individual investments by their contribution to the risk and return of an investor’s portfolio let’s say an investor has a portfolio of three different stocks a b and c and the investor is considering whether to add stock d to this portfolio with the portfolio approach the investor will consider what happens to the return and risk of the portfolio with and without stock d that is called a portfolio approach.

If the investor is not using a portfolio approach then he will simply look at the risk and return of stock d in isolation and as you might imagine the right approach is the portfolio approach because ultimately the wealth of the investor is based on his portfolio so what really matters is the impact on the portfolio of adding or not adding another investment next point portfolio diversification helps investors avoid disastrous investment outcomes let’s say that an investor holds a particular stock and say this stock is the TBR stock in 1999. What is the potentially disastrous situation here it turns out that by the end of 2001 or early 2002 TBR stock had essentially gone down to zero if the investor’s entire net worth was tied up in this one stock then clearly that is a disastrous investment outcome on the other hand if the investor was diversified in the sense that in addition to TBR stock he had several other stocks then the fact that one of the stocks goes down to zero has a relatively small impact on the overall portfolio diversification can also help reduce risk and this is measured using a diversification ratio.

Going back to our simple portfolio stocks a b and c if we look at these three stocks and let’s say that they are from three different industries then there is a chance that when a is going up b is going down and c is staying flat and maybe when a is going down b is going up if these three stocks are from different industries then they do not necessarily move up and down together their movements to some extent cancel each other out so the overall risk of this portfolio is going to be less than the risk of holding any one particular stock this is called a diversification benefit;

Steps in the portfolio management process; there are three major steps

• planning
• execution and
• feedback

In the planning phase we as portfolio managers need to understand our client’s needs and then we need to create a IPS or an investment policy statement this will define the needs of the client it will indicate what his or her risk tolerance is, what the liquidity needs are whether the client has a short-term horizon or a long-term horizon, what are the return requirements given the various constraints that the client has and so on all that needs to be defined in the IPS next comes execution where based on the IPS we do an asset allocation, very broadly speaking asset allocation refers to how the client’s money is allocated across different asset classes simplistically put we can have stocks as one asset class, bonds as another asset class and say alternative investments as a third asset class for a given client we might say that stocks represent 60 percent bonds represent 30 percent and 10 percent goes into alternative investments then we can have sub-asset classes. After we do asset allocation we then need to do security selection which means identifying the specific securities that need to be purchased once we’ve identified the securities then we construct the portfolio which means that we actually need to go purchase those securities after execution we come to step three which is feedback here we need to monitor the portfolio and rebalance we need to check whether a client’s situation has changed and if it has, the portfolio needs to be adjusted we need to check whether the financial markets are performing the way we expected if not then adjustments need to be made we also need to look at whether our stocks and bonds are still in our target asset allocation if it turns out that stocks have done extremely well and stocks have become 90 of the portfolio then we need to rebalance so as to come back to our original asset allocation that is called rebalancing on a periodic basis.

Typically every quarter we need to measure our performance and report as I said this could be every quarter or this could be every month but there needs to be a mechanism whereby we measure performance and report the performance to our clients.