STEPS OF PORTFOLIO MANAGEMENT

PROCESS /STEPS OF PORTFOLIO MANAGEMENT

Specification of Investment objective and Constraints

Selection of Asset Mix

Formulation of Portfolio Strategy

Selection of Securities

Portfolio Execution

Portfolio Revision

Portfolio Evaluation
SPECIFICATION OF INVESTMENT OBJECTIVES AND CONSTRAINTS:

The first step in the portfolio management process is to specify the investment policy that consists
of investment objectives, constraints and preferences of investor. The investment policy can be
explained as follows:

Specification of investment objectives can be done in following two ways:

 Maximize the expected rate of return, subject to the risk exposure being held within a
certain limit (the risk tolerance level).
 Minimize the risk exposure, without sacrificing a certain expected rate of return (the
target rate of return).

An investor should start by defining how much risk he can bear or how much he can afford to lose,
rather than specifying how much money he wants to make. The risk he wants to bear depends on
two factors:
 Financial Situation
 Temperament
To assess financial situation one must take into consideration position of the wealth, major
expenses, earning capacity, etc. and a careful and realistic appraisal of the assets, expenses and
earnings forms a base to define the risk tolerance.

After appraisal of the financial situation assess the temperamental tolerance of risk. Risk tolerance
level is set either by one’s financial situation or financial temperament whichever is lower, so it is
necessary to understand financial temperament objectively. One must realize that risk tolerance
cannot be defined too rigorously or precisely. For practical purposes it is enough to define it as
low, medium or high. This will serve as a valuable guide in taking an investment decision. It will
provide a useful perspective and will prevent from being a victim of the waves and manias that
tend to sweep the market from time to time.
Constraints and Preferences:
 Liquidity:
Liquidity refers to the speed with which an asset can be sold, without suffering any loss to its actual
market price. For example, money market instruments are the most liquid assets, whereas antiques
are among the least liquid.
 Investment horizon:
The investment horizon is the time when the investment or part of it is planned to liquidate to meet
a specific need. For example, the investment horizon for ten years to fund the child’s college
education. The investment horizon has an important bearing on the choice of assets.
 Taxes:
The post – tax return from an investment matters a lot. Tax considerations therefore have an
important bearing on investment decisions. So, it is very important to review the tax shelters
available and to incorporate the same in the investment decisions.
 Regulations:
While individual investors are generally not constrained much by laws and regulations,
institutional investors have to conform to various regulations. For example, mutual funds in India
are not allowed to hold more than 10 percent of equity shares of a public limited company.
 Unique circumstances:
Almost every investor faces unique circumstances. For example, an endowment fund may be
prevented from investing in the securities of companies making alcoholic and tobacco products.

SELECTION OF ASSET MIXES:

Based on the objectives and constraints, selection of assets is done. Selection of assets refers to the
amount of portfolio to be invested in each of the following asset categories:
 Cash:

The first major economic asset that an individual plan to invest in is his or her own house. Their
savings are likely to be in the form of bank deposits and money market mutual fund schemes.
Referred to broadly as ‘cash’, these instruments have appeal, as they are safe and liquid.

 Bonds:
Bonds or debentures represent long-term debt instruments. They are generally of private sector
companies, public sector bonds, gilt-edged securities, RBI saving bonds, national saving
certificates, Kisan Vikas Patras, bank deposits, public provident fund, post office savings, etc.
 Stocks:
Stocks include equity shares and units/shares of equity schemes of mutual funds. It includes
income shares, growth shares, blue chip shares, etc.
 Real estate:
The most important asset for individual investors is generally a residential house. In addition to
this, the more affluent investors are likely to be interested in other types of real estate, like
commercial property, agricultural land, semi-urban land, etc.
 Precious objects and others:

Precious objects are items that are generally small in size but highly valuable in monetary terms.
It includes gold and silver, precious stones, art objects, etc. Other assets includes like that of
financial derivatives, insurance, etc.

3. FORMULATION OF PORTFOLIO STRATEGY:

After selection of asset mix, formulation of appropriate portfolio strategy is required. There are
two types of portfolio strategies, active portfolio strategy and passive portfolio strategy.
 ACTIVE PORTFOLIO STRATEGY:

Most investment professionals follow an active portfolio strategy and aggressive investors who
strive to earn superior returns after adjustment for risk. The four principal vectors of an active
strategy are:
 Market Timing
 Sector Rotation
 Security Selection
 Use of a specialized concept

1. Market timing:
Market timing is based on an explicit or implicit forecast of general market movements. The
advocates of market timing employ a variety of tools like business cycle analysis, advance-decline
analysis, moving average analysis, and econometric models. The forecast of the general market
movement derived with the help of one or more of these tools are tempered by the subjective
judgment of the investor. Often, of course, the investor may go largely by his market sense.
2. Sector Rotation:
The concept of sector rotation can be applied to stocks as well as bonds. It is however, used more
commonly with respect to stock component of portfolio where it essentially involves shifting the
weightings for various industrial sectors based on their assessed outlook. For example if it is
assumed that cement and pharmaceutical sectors would do well compared to other sectors in the
forthcoming period, one may overweight these sectors, relative to their position in market
portfolio. With respect to bonds, sector rotation implies a shift in the composition of the bond
portfolio in terms of quality, coupon rate, term to maturity and so on. For example, if there is a rise
in the interest rates, there may be shift in long term bonds to medium term or even short-term
bonds. But we should remember that a long-term bond is more sensitive to interest rate variation
compared to a short-term bond.
3. Security Selection:
Security selection involves a search for underpriced securities. If an investor resort to active stock
selection, he may employ fundamental and or technical analysis to identify stocks that seems to
promise superior returns and overweight the stock component of his portfolio on them. Likewise,
stocks that are perceived to be unattractive will be under weighted relative to their position in the
market portfolio. As far as bonds are concerned, security selection calls for choosing bonds that
offer the highest yield to maturity at a given level of risk.
4. Use of a specialized Investment Concept:
A fourth possible approach to achieve superior returns is to employ a specialized concept or
philosophy, particularly with respect to investment in stocks. As Charles D. Ellis words says, a
possible way to enhance returns “is to develop a profound and valid insight into the forces that
drive a particular group of companies or industries and systematically exploit that investment
insight or concept
PASSIVE PORTFOLIO STRATEGY:
The passive strategy rests on the tenet that the capital market is fairly efficient with respect to the
available information. The passive strategy is implemented according to the following two
guidelines:
  Create a well-diversified portfolio at a predetermined level of risk.
 Hold the portfolio relatively unchanged over time, unless it becomes inadequately
diversified or inconsistent with the investor’s risk-return preferences.

4. SELECTION OF SECURITIES:
The following factors should be taken into consideration while selecting the fixed income avenues:
SELECTION OF BONDS (fixed income avenues)
Yield to maturity: The yield to maturity for a fixed income avenue represents the rate of return
earned by the investors if he invests in the fixed income avenue and holds it till its maturity.
 Risk of default:

To assess the risk of default on a bond, one may look at the credit rating of the bond. If no credit
rating is available, examine relevant financial ratios (like debt-to-equity ratio, times interest earned
ratio, and earning power) of the firm and assess the general prospects of the industry to which the
firm belongs
 Tax Shield:

In yesteryears, several fixed income avenues offered tax shield, now very few do so.
 Liquidity:

If the fixed income avenue can be converted wholly or substantially into cash at a fairly short
notice, it possesses liquidity of a high order.

SELECTION OF STOCK (Equity shares)

Three board approaches are employed for the selection of equity shares:

 Technical analysis looks at price behavior and volume data to determine whether the
share will move up or down or remain trend less.

 Fundamental analysis focuses on fundamental factors like the earnings level, growth
prospects, and risk exposure to establish the intrinsic value of a share. The
 recommendation to buy, hold, or sell is based on a comparison of the intrinsic value
and the prevailing market price.

 Random selection approach is based on the premise that the market is efficient and
securities are properly priced.

5. PORTFOLIO EXECUTION:
The next step is to implement the portfolio plan by buying or selling specified securities in given
amounts. This is the phase of portfolio execution which is often glossed over in portfolio
management literature. However, it is an important practical step that has a significant bearing on
the investment results. In the execution stage, three decision need to be made, if the percentage
holdings of various asset classes are currently different from the desired holdings.
6. PORTFOLIO REVISION:
In the entire process of portfolio management, portfolio revision is as important stage as portfolio
selection. Portfolio revision involves changing the existing mix of securities. This may be effected
either by changing the securities currently included in the portfolio or by altering the proportion
of funds invested in the securities. New securities may be added to the portfolio or some existing
securities may be removed from the portfolio. Thus it leads to purchase and sale of securities. The
objective of portfolio revision is similar to the objective of selection i.e. maximizing the return for
a given level of risk or minimizing the risk for a given level of return. The need for portfolio
revision has aroused due to changes in the financial markets since creation of portfolio. It has
aroused because of many factors like availability of additional funds for investment, change in the
risk attitude, change investment goals, the need to liquidate a part of the portfolio to provide funds
for some alternative uses. The portfolio needs to be revised to accommodate the changes in the
investor’s position.
Portfolio Revision basically involves two stages:
 Portfolio Rebalancing:

Portfolio Rebalancing involves reviewing and revising the portfolio composition (i.e. the stock-
bond mix). There are three basic policies with respect to portfolio rebalancing: buy and hold policy,
constant mix policy, and the portfolio insurance policy. Under a buy and hold policy, the initial
portfolio is left undisturbed. It is essentially a ‘buy and hold’ policy. Irrespective of what happens
to the relative values, no rebalancing is done. For example, if the initial portfolio has a stock-bond
mix of 50:50 and after six months it happens to be say 70:50 because the stock component has
appreciated and the bond component has stagnated, than in such cases no changes are made.
The constant mix policy calls for maintaining the proportions of stocks and bonds in line with their
target value. For example, if the desired mix of stocks and bonds is say 50:50, the constant mix
calls for rebalancing the portfolio when relative value of its components change, so that the target
proportions are maintained. The portfolio insurance policy calls for increasing the exposure to
stocks when the portfolio appreciates in value and decreasing the exposure to stocks when the
portfolio depreciates in value. The basic idea is to ensure that the portfolio value does not fall
below a floor level.
 Portfolio Upgrading:

While portfolio rebalancing involves shifting from stocks to bonds or vice versa, portfolio-
upgrading calls for re-assessing the risk return characteristics of various securities (stocks as well
as bonds), selling over-priced securities, and buying underpriced securities. It may also entail other
changes the investor may consider necessary to enhance the performance of the portfolio.
7. PORTFOLIO EVALUATION:
Portfolio evaluation is the last step in the process of portfolio management. It is the process that is
concerned with assessing the performance of the portfolio over a selected period of time in terms
of return and risk. Through portfolio evaluation the investor tries to find out how well the portfolio
has performed. The portfolio of securities held by an investor is the result of his investment
decisions. Portfolio evaluation is really a study of the impact of such decisions. This involves
quantitative measurement of actual return realized and the risk born by the portfolio over the period
of investment. It provides a mechanism for identifying the weakness in the investment process and
for improving these deficient areas. The evaluation provides the necessary feedback for designing
a better portfolio next time.