In this reading, we will see the importance of the portfolio approach to investing, investment needs of different types of investors, steps in the portfolio management process, and how to compare various types of pooled investments.
The portfolio approach means evaluating individual investments based on their contribution to the investment characteristics of the portfolio. Assume an investor’s portfolio has three stocks A, B, and C. He is evaluating whether to add another stock, D, to the portfolio. In a portfolio approach, the investor will analyze what will happen to the risk and return of the portfolio with and without stock D; whereas, in an isolated approach, he will only look at the merits and demerits of the stock D.
Diversification helps investors avoid disastrous outcomes. For instance, many Enron employees held all of their retirement funds in Enron shares. When the share tumbled from $90 to zero between January 2001 and 2002, it completely ruined their financial wealth; this example emphasizes the need to diversify one’s portfolio. Instead, if the Enron employees had held shares of other companies or other products, the consequence would not have been as bad.
Diversification also helps investors reduce risk without compromising their expected rate of return. A simple measure of diversification risk is the diversification ratio. Let us take the example of the same portfolio consisting of three stocks: A, B, and C with each stock belonging to a different industry. There is a high probability that the movements of A, B, and C are not correlated with each other, i.e., when A moves up, B may move down or C may move down. The benefit of diversification is that the movements of individual stocks cancel each other out to some extent.
The benefits of diversification in risk reduction for an equally weighted portfolio is measured by diversification ratio.
The composition of the portfolios also matters for the risk-return trade-off. The table below shows two portfolios with different compositions of A, B, and C.
|Two portfolios with same stocks but different compositions|
|Weight of each stock|
|Portfolio||Stock A||Stock B||Stock C||Expected Return||Standard Deviation|
As you can see both the portfolios have the same expected return, but Portfolio 1 has a better risk-return trade-off than Portfolio 2 as the risk assumed is lower for the same return.
However, an important point to note is that portfolios do not provide guaranteed downside protection. Although portfolio diversification reduces risk, the level of risk reduction is not the same at times of financial crises. The benefits of risk reduction from diversification are best seen under normal market conditions.
The three steps in the portfolio management process are planning, execution, and feedback.
In this step, the portfolio manager needs to understand a client’s needs and develop an investment policy statement (IPS). IPS is a written document that states the client’s objectives and constraints. Objectives are return and risk objectives which may be stated in absolute terms or relative terms. Constraints may include liquidity, unique circumstances, time horizon, legal, and taxes.
Based on the IPS, a portfolio is constructed in this step. Under execution, the first activity is asset allocation. Here the portfolio manager decides what asset classes must be included in the client’s portfolio and in what proportion. Stocks, bonds, and alternative investments are examples of different asset classes. As an example, a client’s asset allocation may consist of 60% equities, 30% fixed-income securities and 10% alternative investments.
Asset allocation is followed by security selection which is the analysis and selection of individual securities. In other words, the specific securities to be purchased are identified. For example, if 60% is allocated to equities, the analyst will identify what specific stocks to purchase.
Once the securities are selected, they are purchased through a broker or dealer. This is called portfolio construction.
A portfolio manager’s responsibility does not end with constructing a portfolio. The portfolio also needs to be monitored and rebalanced at regular intervals. For example, if the stock market performs very well in a particular period, the asset allocation drifts away from the intended levels. In this case the portfolio needs to be rebalanced. The frequency at which performance is measured is pre-decided – for instance, it could be on a monthly or quarterly basis.
The feedback step also involves performance measurement and reporting. Analysis must include how the portfolio performed over time, were the objectives met, what assets attributed to the good/poor performance, how the portfolio performed against the benchmark, and so on.
The investment needs of different client types are given in the following table:
|Investment Horizon||Risk Tolerance||Income Needs||Liquidity Needs|
|Individual Investors||Depends on individual goals.||Depends on the ability and willingness to take risk.||Depends on rationale behind investment.||Depends on the individual.|
|Banks||Short||Low||Pay interest on deposits.||High, to meet the daily withdrawals.|
|DB pension plans||Long, depends on the employee profile.||High for longer investment horizon.||High for mature funds (payouts are closer), low for growing funds.||Low|
|Endowments and foundations
|Long||High||Meet spending obligations.||Low|
|Insurance Companies (P&C)||Short||Low||Low||High|
|Insurance Companies (Life)||Long||Low (because of high liquidity needs).||Low||High|
|Mutual Funds||Varies by fund.||Varies by fund.||Varies by fund.||High, to meet redemptions.|
The two types of pension plans are:
Defined Contribution Plan: Company contributes an agreed-upon amount to the plan. The agreed-upon amount is recognized as a pension expense on the income statement and the contributed amount is treated as an operating cash outflow. In DC plan, the investment and inflation risk is borne by the employee.
Defined Benefit Plan: A company makes promises of future benefits to be paid to the employees.