For any investor, year-end is the right time for contemplation. It is also an opportunity to consider the ways you can make your portfolio work better.
Introspection — involving trying to determine the areas where you are weak and strong, and how you can improve your weaknesses and leverage upon the strengths — is not easy. It is a good idea to introspect on a particular portfolio of assets several times in a single day or even over a couple of days before writing down your thoughts.
First and foremost, it forces you to reflect on your investments. This is more important than you might think, because many problems with well- or ill-diversified asset classes often come out as a result of some experiences in life or things that you’ve never been able to really think about. Two, it reveals how deep and personal that asset class connection is. In fact, portfolio is a representation of you as an individual, your work, your values, and the things that you love. When you cast it aside and make it separate from these things, it becomes abstract and valueless. The answers you derive will often help you make some difficult choices.
Evaluate your portfolio
Economies are dynamic; they are affected by numerous industry struggles, politics and changing demographics and social attitudes. Thus, the portfolio will require constant monitoring and updation to reflect changes in financial market expectations. To judge the performance of the portfolio, the investment policy statement helps to a great extent. Performance cannot be judged without an objective standard; the investment policy statement provides just that. The portfolio’s performance should be compared to guidelines specified in the policy statement, not on the overall return.
Although portfolios are obviously composed of different individual stocks, investors typically ask, “What happened to the market today?” The reason is that if an investor owns more than a few stocks, it is cumbersome to follow each share individually to determine the composite performance of the portfolio. Also, there is an intuitive notion that most individual shares or bonds move with the aggregate market. It is always better to have a benchmark portfolio, or comparison standard at the time of evolving your investment policy statement.
The risk of the benchmark, and the assets included in it, should agree with your risk preferences and investment needs. In turn, the investment performance of the portfolio should be compared to this benchmark portfolio. For example, an investor who specifies low-risk investments in the policy statement should compare the portfolio performance with a low-risk benchmark portfolio. Likewise, an investor seeking high-risk, high-return investments should compare the portfolio’s performance with a high-risk benchmark portfolio.
To conclude, by means of introspection, investors can assess their needs and risk tolerance. Policy statements help them correctly identify appropriate objectives and constraints.
The writer is associate professor of finance & accounting, IIM, Shillong