Portfolio Management | History | Meaning | Steps involved

History of Portfolio Management

Investing in corporate securities is profitable as well as exciting.O ne should not forget the element of risks from investing in individual security. Risk arises when there is a possibility of variation around expected return from the security. As all securities carry varying degrees of risks, holding more than one security at a time enables an investor to spread his risks.

The investor hopes that even if one security incurs a loss the rest will provide some protection from an extreme loss. Thus, portfolios or combination of securities are thought of as a device to spread risk over many securities.

In this context, portfolio is defined as

the composite set of ownership rights to financial assets in which the investor wishes to invest.

In olden days, the traditional portfolio managers diversified funds over securities of large number of companies based on intuition. They had no real knowledge of implementing risk reduction.

Since 1950, a body of knowledge has been built up which quantifies the expected risk and also the riskiness of the portfolio. The portfolio theory has been developed to provide the management a technique to evaluate the merits and demerits of investment portfolio.

Meaning of portfolio management

To have a better understanding of portfolio management, it is essential to know what portfolio is. Portfolio means a combination of financial assets and physical assets. The financial assets are shares, debentures and other securities while physical assets include gold, silver, real estates, rare collections, etc.

The essence of portfolio is that assets are held for investment purposes and not for consumption purposes.

Definition of Portfolio Management

Portfolio management can be defined as

the process of selecting a bunch of securities that provides the investing agency a maximum return for a given level of risk or alternatively ensures minimum risk for a given level of return.

Investment portfolio composing securities that yield a maximum return for given levels of risk or minimum risk for given levels of returns are termed as “efficient portfolio”.

The investors, through portfolio management, attempt to maximize their expected return consistent with individually acceptable portfolio risk.

Portfolio management thus refers to investment of funds in such combination of different securities in which the total risk of portfolio is minimized while expecting maximum return from it.

As returns and prices of all securities do not move exactly together, variability in one security will be offset by the reverse variability in some other security. Ultimately, the overall risk of the investor will be less affected.

Steps involved in Portfolio management process

Portfolio management involves complex process which the following steps to be followed carefully.

  1. Identification of objectives and constraints.
  2. Selection of the asset mix.
  3. Formulation of portfolio strategy
  4. Security analysis
  5. Portfolio execution
  6. Portfolio revision
  7. Portfolio evaluation.

Now each of these steps can be discussed in detail.

1. Identification of objectives and constraints

The primary step in the portfolio management process is to identify the limitations and objectives. The portfolio management should focus on the objectives and constraints of an investor in first place. The objective of an Investor may be income with minimum amount of risk, capital appreciation or for future provisions.  The relative importance of these objectives should be clearly defined.

2. Selection of the asset mix

The next major step in portfolio management process is identifying different assets that can be included in portfolio in order to spread risk and minimize loss.

In this step, the relationship between securities has to be clearly specified. Portfolio may contain the mix of Preference shares, equity shares, bonds etc. The percentage of the mix depends upon the risk tolerance and investment limit of the investor.

3. Formulation of portfolio strategy

After certain asset mix is chosen, the next step in the portfolio management process is formulation of an appropriate portfolio strategy. There are two choices for the formulation of portfolio strategy, namely

  1. an active portfolio strategy; and
  2. a passive portfolio strategy.

An active portfolio strategy attempts to earn a superior risk adjusted return by adopting to market timing, switching from one sector to another sector according to market condition, security selection or an combination of all of these.

A passive portfolio strategy on the other hand has a pre-determined level of exposure to risk. The portfolio is broadly diversified and maintained strictly.

4. Security analysis

In this step, an investor actively involves himself in selecting securities.

Security analysis requires the sources of information on the basis of which analysis is made. Securities for the portfolio are analyzed taking into account of their price, possible return, risks associated with it etc. As the return on investment is linked to the risk associated with the security, security analysis helps to understand the nature and extent of risk of a particular security in the market.

Security analysis involves both micro analysis and macro analysis. For example, analyzing one script is micro analysis. On the other hand, macro analysis is the analysis of market of securities. Fundamental analysis and technical analysis helps to identify the securities that can be included in portfolio of an investor.

5. Portfolio execution

When selection of securities for investment is complete the execution of portfolio plan takes the next stage in a portfolio management process. Portfolio execution is related to buying and selling of specified securities in given amounts. As portfolio execution has a bearing on investment results, it is considered one of the important step in portfolio management.

6. Portfolio revision

Portfolio revision is one of the most important step in portfolio management. A portfolio manager has to constantly monitor and review scripts according to the market condition. Revision of portfolio includes adding or removing scripts, shifting from one stock to another or from stocks to bonds and vice versa.

7. Performance evaluation

Evaluating the performance of portfolio is another important step in portfolio management. Portfolio manager has to assess the performance of portfolio over a selected period of time. Performance evaluation includes assessing the relative merits and demerits of portfolio, risk and return criteria, adherence of the portfolio management to publicly stated investment objectives or some combination of these factors.

The quantitative measurement of actual return realized and the risk borne by the portfolio over the period of investment is called for while evaluating risk and return criteria. They are compared against the objective norms to assess the relative performance of the portfolio.

Performance evaluation gives a useful feedback to improve the quality of the portfolio management process on a continuing basis.

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