This is a process where an integrated set of steps are undertaken in a consistent manner to create and maintain an appropriate portfolio (combination of assets) to meet an investor's goals. These activities combine in a logical manner to produce a desired product. The process is dynamic and applies to all types of investments, such as bonds, stocks, real estate, gold and collectibles; as also to various investors, including trusts, insurance companies, MFs, individual investors, endowments, foundations, etc.
Documenting a policy statement
The first step is to document a policy statement. Essentially, it is a road map wherein the investor specifies the types of risks they are willing to take and their investment goals and constraints. All decisions are based on the policy statement to ensure they are appropriate. A policy statement provides discipline and reduces the possibility of making hasty and inappropriate decisions.
Deciding on investment strategy
In the second step of the portfolio management process, the investor should review the current financial and economic conditions and forecast future trends. The investors needs and financial market expectations jointly determine the strategy.
Creating strategic asset allocation
The third step is to construct the portfolio through strategic asset allocation. With the policy statement and financial market forecasts as inputs, one can determine how to allocate funds across asset classes. This involves constructing a portfolio that will minimise the investor's risks while meeting his needs. The investor may seek both single- and multi-period perspectives in the return and risk characteristics of asset allocation. While a single-period perspective has the advantage of simplicity, a multi-period perspective can address liquidity and tax considerations that arise from rebalancing portfolios over time, as well as serial correlation (long- and short-term dependencies) in returns, but is costlier to implement.
An investor needs to systematically review the risk attributes of assets as well as economic and capital market factors. For instance, suppose the policy allocation calls for an initial portfolio with a 70% weighting to stocks and 30% to bonds. Suppose, the value of the stock holdings then grows 40% while the value of the bond holdings grows 10%. The new weighting is roughly 75% in stocks and 25% in bonds. To bring the portfolio back into compliance with policy, it must be rebalanced to the long-term policy weights. In any event, the rebalancing decision is a crucial one that must take into account factors like transaction costs and taxes. It has a major impact on the attainment of objectives.
Often, one can examine a portfolios performance, in terms of total returns, as coming from three sources: decisions regarding strategic asset allocation, market timing and securities selection. However, portfolio management is frequently conducted with reference to a benchmark, or for some entities, with reference to a stream of projected liabilities or a specified target rate of return. As a result, relative portfolio performance evaluation is often of key importance.
In the last few decades, portfolio management has become more of a science-based discipline, somewhat analogous to engineering and medicine. As in these other fields, advances in basic theory, technology and market structure constantly translate into improvement in products and practices.
The writer is associate professor of finance and accounting at IIM Shillong