The modern portfolio management process is not anymore a simple activity. It has developed into a quantitatively complex process that can be described using five steps:
Specification of investment objectives and constraints
Investment needs to be guided by a set of objectives. The main objectives taken into consideration by investors are capital appreciation, current income and safety of principal. The relative importance of each of these objectives needs to be determined. The main aspect that affects the objectives is risk. Some investors are risk takers while others try to reduce risk to the minimum level possible. Identification of constrains arising out of liquidity, time horizon, tax and special situations need to be addressed.
Choice of the asset mix
In investment management the most important decision is with respect to the asset mix decision. It is to do with the proportion of equity shares or shares of equity oriented mutual funds i.e. stocks and proportion of bonds in the portfolio. The combination on the number of stocks and bonds depends upon the risk tolerance of the investor. This step also involves which classes of asset investments will be placed and also determines which securities should be purchased in a particular class.
Formulation of portfolio strategy
After the stock – bond combination is chosen, it is important to formulate a suitable portfolio strategy. There are two types of portfolio strategies. The first is an active portfolio strategy which aims to earn greater risk adjusted returns depending on the market timing, sector rotation, security selection or a mix of these. The second strategy is the passive strategy which involves holding a well diversified portfolio and also maintaining a pre-decided level risk.
Selection of securities
Investors usually select stocks after a careful fundamental and technical analysis of the security they are interested in purchasing. In case of bonds credit ratings, liquidity, tax shelter, term of maturity and yield to maturity are factors that are considered. Portfolio Execution This step involves implementing the formulated portfolio strategy by buying or selling certain securities in specified amounts. This step is the one which actually affects investment results. Portfolio Revision Fluctuation in the prices of stocks and bonds lead to changes in the value of the portfolio and this calls for a rebalancing of the portfolio from time to time. This principally involves shifting from bonds to stocks or vice-versa. Sector rotation and security changes may also be needed.
The assessment of the performance of the portfolio should be done from time to time. It helps the investor to realize if the portfolio return is in proportion with its risk exposure. Along with this it is also necessary to have a benchmark for comparison with other portfolios that have a similar risk exposure.