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A Complete Guide to Portfolio Management Strategy

Portfolio management is the art and science of selecting and overseeing a group of investments that meet the long-term financial objectives and risk tolerance of a client, a company, or an institution.

Portfolio management requires the ability to weigh strengths and weaknesses, opportunities and threats across the full spectrum of investments. The choices involve trade-offs, from debt versus equity to domestic versus international and growth versus safety.

What is Portfolio Management Strategy?

There is no one “best” or “correct” way to manage a portfolio, but a range of approaches to investing.

The “best” portfolio depends on the goals of the portfolio manager/advisor and the client. Typical goals of a client include:

  • Maximizing returns
  • Minimizing volatility (risk)
  • Minimizing taxes
  • Balancing competing goals

Portfolio management strategies vary based on risk tolerance, time horizon, and primary investment objectives.

Investment management strategies generally fall into a number of categories, each of which presents various risks and returns.

Conservative portfolios are generally less risky than growth portfolios and tend to have modest long-term returns.

Growth portfolios tend to pursue higher long-term returns with stronger short-term volatility.

Balanced portfolios typically pursue returns that mirror an overall asset class, like stocks, bonds or cash, and may include cash, stocks and bonds.

Business investment approaches may fall into several general categories:

Value-oriented strategies: Invest in assets that are under-priced relative to their intrinsic worth.

Growth-oriented strategies: Invest in assets experiencing above-average growth.

Combination and alternative investment strategies: Invest in assets that achieve a mix of goals.

Global investing strategies: Invest in businesses, currencies, commodities and other assets located outside the client’s home country.

What is Portfolio Management?

Portfolio management may be viewed by client and advisor as the ongoing process of considering and selecting investments for a client’s portfolio to support the financial goals of the client.

This process may involve the purchase and sale of existing investments, the purchase of new investment products, portfolio withdrawals and payments, and potential alternative uses of funds.

The client’s needs must guide the ongoing management process. Typically, a financial advisor and an investment manager work in tandem with a client to create and manage a portfolio that will achieve the client’s financial objectives.

Client/Investor’s needs may include:

  • Making withdrawals and distributions
  • Considering investment withdrawals
  • Reallocating investments to respond to changes in financial goals
  • Creating a potential income stream
  • Controlling risk
  • Maximizing asset value

We discuss these in detail in “Planning for Financial Goals” and “What Investors Need to Know about Risk.”

What is Portfolio Management Risk?

The portfolio management strategy a client chooses depends on the potential risk-reward ratio. In order to provide a return that’s higher than the risk-free rate, there must be exposure to risk.

Portfolio management strategy must be aligned with the client’s tolerance for risk.

Risk is inherent in investments. There are three main types of investment risk:

Investment type Examples of risks Risk description Conservative Cash Fixed income investments Maintains principal levels but lower returns Equities Market risk Equity markets tend to follow a cycle of high and low prices over time Fixed income Credit and interest rate fluctuations Risky growth Private equity Convolutions in the market Fannie Mae, Freddie Mac and the bank lending crisis Other real estate Mortgage foreclosures Exotic investments Economic and political events Exotic transactions have the potential to be highly volatile and unpredictable

Portfolio management strategies are risk-tolerant, moderately conservative or aggressive depending on the intended goals.

Taxable accounts can offer tax benefits and provide greater flexibility. These investment accounts are generally managed more aggressively, and may have a higher component of growth investments.

Retirement accounts like 401(k)s and IRAs can provide a tax shelter for portions of a portfolio. These investment accounts are generally managed more conservatively and may have a higher component of fixed income investments.

How does Portfolio Management Work?

Portfolio management starts with the selection and acquisition of a group of investments that complement each other and have similar risk and return characteristics, called asset class diversification.

A “second generation” of portfolio management focuses on the selection of available investment vehicles that are capable of significantly outperforming the overall market, called active portfolio management.

A third generation combines both approaches.

Diversification is the foundation.

The term diversification refers to an investment strategy that seeks to reduce investment risk by investing in a number of investments. The goal is to achieve a relatively stable return over time, and reduce the amount of risk at the same time.

Just as a portfolio of individual stocks can be riskier than a portfolio of mutual funds, a portfolio consisting of a number of asset classes each representing a group of investments can perform better, with less risk, than any one of the individual asset classes that make up the portfolio.

It doesn’t matter how good the asset class is, if it is not within a portfolio that is well diversified enough to reduce risk, it’s going to be risky.

Assets are typically diversified across several categories, each of which may present a different level of risk, return, liquidity, transparency and attractiveness to investors.

Asset class names are generally in plural format because the group of assets themselves are typically not identical.

Diversification of investments can help reduce risk and maximize returns, as long as the investment mix is properly constructed.

Diversification is also one of the primary portfolio management objectives. By their nature, assets in one group have different characteristics and risks than assets in other groups.

Asset class diversification also extends to active and passive management and geographic diversification.

Ultimately, the “best” portfolio is the portfolio that best meets the client’s goals and with tolerable risk.

The “best” portfolio is the only proper measure for judging the success of the portfolio management process.

Portfolio construction guidelines to help keep the portfolio on course are:

  • Reallocate the portfolio periodically (for example, quarterly).

The client’s asset allocation should reflect their time horizon and primary investment objectives.

The client’s allocation between risk-tolerant and risk-averse investments should reflect their risk tolerance and investment objectives.

Another way to think of asset class diversification is to think of risk tolerance and investment objectives.

The client’s allocation between risk-tolerant and risk-averse investments should reflect their risk tolerance and investment objectives.

The client’s allocation between risk-tolerant and risk-averse investments should reflect their risk tolerance and investment objectives.

It’s not just a question of whether to go all in on the stock market or stick with the safe bond market. It’s about the mix of the two that makes sense.

The client needs to have a well-defined investment plan.

Components of the investment plan may include:

  • Assets allocated to cash
  • Assets allocated to stocks
  • Assets allocated to bonds
  • Assets allocated to cash equivalents

The allocation should be reviewed periodically (annually or more often) by the client and financial advisor.

Changes need to be communicated to the investment manager, who implements the change.

Components of the investment plan may include:

  • Assets allocated to cash
  • Assets allocated to stocks
  • Assets allocated to bonds
  • Assets allocated to cash equivalents

The allocation should be reviewed periodically (annually or more often) by the client and financial advisor.

Changes need to be communicated to the investment manager, who implements the change.

If the client’s time horizon is long term (10 years or more), the allocation will not need to change from year to year.

In other words, when the investment allocation is changed, the changes should be small and infrequent.

The client should be made aware of what is going on with the portfolio.

The client must know where their investments are invested.

The client must also know how their returns compare with similar returns on investments that are similar in kind.

The client should strive to achieve a consistent investment mix.

Smaller investment firms often specialize in investment counseling and second-generation portfolio management, which focuses on active portfolio management. Some larger firms also offer this service.

Asset allocation is the most important component of any portfolio management plan.

Asset allocation involves deciding how much money to allocate to each asset class, which is based on the expected return of the different asset classes and the risk associated with each asset class.

If an investment portfolio is constructed with lower risk asset classes like bonds and cash equivalents, and a greater concentration of higher risk assets like equities and other growth assets, the portfolio will typically provide a higher return if the anticipated return is achieved.

There is no way to know in advance what return on investment will be, but there are some tools and techniques that can be used:

  • Portfolio Management and Return
  • Portfolio management involves targeting a desired risk-adjusted return.
  • The risk-adjusted return is calculated based on the risks associated with an investment.

When measuring return, it’s important to consider the risk of the investments used to achieve the return. For example, higher return may be associated with a higher level of risk; therefore, the return may not be worth the risk that was taken.

Additionally, the analysis should consider any costs that are associated with achieving the return.

Fees (expenses) associated with investment products should be considered in the analysis because they can have a significant impact on the overall return.

When it comes to run rate, four major constituents should be included:

|Growth of business

|Losses on property, plant & equipment

|Other expense

|EBIT (earnings before interest and taxes)

|Revenue growth or decline

|Cost of growth (expenses)

|Earnings growth or decline

|Return on equity (earnings/shareholders’ equity)

|Return on assets (earnings/assets)

|Net profit margin (net margin/net sales)

|Spread (revenue/cost)

|Profit margin (sales/cost)

|Operating profit margin (total revenue/total cost)

|Operating margin (operating profit/total revenue)

[Note for business schools, finance and economics students: analysis and interpretation of financial statements]

For investors, it’s usually a good idea to analyze the business using the industry return on equity and the number of years of credit.

Return on equity (ROE) is the net profit divided by common shareholders’ equity.

The return on equity (ROE) is equal to net profit for the year divided by total common equity.

The return on equity (ROE), one of the key profitability ratios, measures profitability considering both sides of the equity account — retained earnings (to reflect the return to shareholders) and common equity (to reflect the return to common shareholders).

The return on equity (ROE), one of the key profitability ratios, measures profitability considering both sides of the equity account — retained earnings (to reflect the return to shareholders) and common equity (to reflect the return to common shareholders).

The return on equity (ROE) is equal to net profit for the year divided by total common equity.

If retained earnings are included, the return on equity (ROE) is a more comprehensive measure of profitability because it reflects the return to both equity investors (shareholders and common shareholders) and debt holders.

Relative return

Business Value >Return Calculator >Return on Equity (ROE)

Return on equity is a profitability ratio that uses a company’s net profit (or loss) and leverage to calculate how many dollars of profit are created by each dollar of shareholders’ equity.

If the return on equity is growing, management is creating more profit from each dollar of equity than it did in the past.

In contrast, if the return on equity is falling, then management is creating less profit from each dollar of equity.

The return on equity is a profitability ratio that uses a company’s net profit (or loss) and leverage to calculate how many dollars of profit are created by each dollar of shareholders’ equity.

If the return on equity is growing, management is creating more profit from each dollar of equity than it did in the past.

In contrast, if the return on equity is falling, then management is creating less profit from each dollar of equity.

The return on equity is a profitability ratio that uses a company’s net profit (or loss) and leverage to calculate how many dollars of profit are created by each dollar of shareholders’ equity.

If the return on equity is growing, management is creating more profit from each dollar of equity than it did in the past.

In contrast, if the return on equity is falling, then management is creating less profit from each dollar of equity.

The return on equity is a profitability ratio that uses a company’s net profit (or loss) and leverage to calculate how many dollars of profit are created by each dollar of shareholders’ equity.

If the return on equity is growing, management is creating more profit from each dollar of equity than it did in the past.

In contrast, if the return on equity is falling, then management is creating less profit from each dollar of equity.

The return on equity (ROE) is equal to net profit for the year divided by total common equity.

If retained earnings are included, the return on equity (ROE) is a more comprehensive measure of profitability because it reflects the return to both equity investors (shareholders and common shareholders) and debt holders.

The return on equity (ROE), one of the key profitability ratios, measures profitability considering both sides of the equity account — retained earnings (to reflect the return to shareholders) and common equity (to reflect the return to common shareholders).

The return on equity (ROE), one of the key profitability ratios, measures profitability considering both sides of the equity account — retained earnings (to reflect the return to shareholders) and common equity (to reflect the return to common shareholders).

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