Portfolio Management And Diversification PORTFOLIO MANAGEMENT AND DIVERSIFICATION Introduction: Portfolio management is a conglomeration of securities as whole, rather than unrelated individual holdings. Portfolio management stresses the selection of securities for inclusion in the portfolio based on that security’s contribution to the portfolio as a whole. This purposes that there some synergy or some interaction among the securities results in the total portfolio effect being something more than the sum of its parts. When the securities are combined in a portfolio, the return on the portfolio will be an average of the returns of the securities in the portfolio.
For example, if a portfolio was comprised on equal positions in two securities, whose returns are 15% and 20%, the return on the portfolio, will the average of the returns of the two securities in the portfolio, or 17.5%. From this we will discuss the process of creating a diversified portfolio. The diversified portfolio is a theory of investing that reduces the risk of losing all your money when “all your eggs” are not in one basket. Diversification limits your risk an over the long run, can improve your total returns. This is achieved by putting assets in several categories of investments.Portfolio Process: The portfolio process is as follows: 1.
Designing an investment objective; 2. Developing and implementing an asset mix; 3. Monitoring the economy and the markets; 4. Adjusting the portfolio and measuring the performance Due to the intensity of each of the four items, we will be covering only the first two. 1.Investment Objective: This topic is broad and contains three major divisions. They are foundation objectives, constraints and major objectives. Foundation Objectives: These objectives generally receive the most attention from investors and are determined by thorough determination of your needs, preferences and resources.
? Return – you need to determine whether you prefer a strategy of return maximization, where assets are invested to make the greatest return possible while staying within the risk tolerance level, or whether a required minimum return with certainty is preferable, generating only as much return with emphasis on risk reduction. ? Risk – There are many ways to assess the risk tolerance of any particular investor, from the least knowledgeable of investments to the very sophisticated investor. Besides the risk you are willing to take, there must be a measure of the risk associated with each security be considered for the inclusion in the portfolio.It is important to recognize the difference between the risk of an individual security and the risk of the portfolio as a whole. The risk of a portfolio is less than the average risk of its holdings, your risk tolerance should be matched to the risk of the overall portfolio and not to the risk of each security. ? Inflation – Although some degree of inflation protection is needed, the extent will vary depending upon the time horizon and the goal of using the portfolio to generate income for future cash consideration. Whereas, someone using a short term trading strategy and interested in maximization of capital gains may concentrate less on this factor.
? Time Horizon – The time horizon is the period of time from the present until the next major change in your circumstances. A good portfolio design will reflect this time change. For example – at 25 years of age and normal retirement at age 60 does not necessarily mean the time horizon is 35 years.
Different events in your life can represent the end of one time horizon and the beginning of a new time horizon and a need for a complete rebalancing of your portfolio. These events could include finishing university, purchase of a new home and many others beside retirement. ? Liquidity – In portfolio management this is the amount of cash and near-cash in the portfolio.
For liquidity purposes, if you are wealthy and risk tolerant you may choice to have about 5% of your portfolio in cash, this does mean that the cash component will never rise above 5% due to the market cycle. Whereas those who are risk adverse may choice to have 10% or more in cash. ? Taxation – The level of taxation will determine the choices that are made in regards to the choice of tax advantaged securities such as some limited partnerships as well as the choice of tax deferral plans.? Market timing – Your investment strategy could include the buy and hold approach or the market timing approach of investment. Buy and hold means long holding periods through various market cycles for long-term growth and income. Market timing involves timing the short term entry and exit points in the market in pursuit of quick trading, gains over and above the commissions incurred.
There are some other reasons why a portfolio foundation objective maybe determined. They could include the desire to retire at a certain age, acquisition of a business, a vacation property, or the pursuit of some other tangible goal.Constraint Objectives: The constraints provide boundaries that may hinder or prevent you from satisfying your foundation or major objectives.
? Legal – Any investment activity which disregards any act, by-law, regulation, rule or the criminal code must be considered a constraint. For example if your not married you are restricted from participating in a spousal RRSP and therefore from its benefits of income splitting. ? Moral/Ethical – When considering investment activities, your research should include whether the company that you are investing in follows your moral guidelines. For example, if you have personal convictions against alcohol or tobacco usage, then you would not invest in these securities.? Basic Minimum Income – Your portfolio should be structured to generate a good total return that is required to meet your financial needs and also cover any tax implications, without eroding the value of your portfolio. ? Realism – You need to be realistic in your determining the return that can be provided by your portfolio. By knowing your constraints of investing, this will assist in developing a portfolio that suits your needs. Major Objectives: The three major objectives outlined below will assist you in determining the appropriate asset allocation for your portfolio.
? Preservation of Capital – If one of your major strategies is preserving your initial capital investment, this can be achieved by investing in securities that are considered risk free and which will mature in one years time – restoring your principal amount. For example you have an accou …