What are the elements or phases of portfolio management framework?


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Investment management also referred to as portfolio management, is a complex process or activity that may be divided into eight broad phases / elements.

Phase 1: Review of Investment Avenues: The first step in the investment management process is to understand the broad characteristics of various investment avenues available.

 

Phase 2: Specification of investment Objective and Constraints: The second step in the portfolio management process is to list down investment objectives and constraints.

 

Investment objective can be:

1.      Income: to provide a steady stream of income through regular interest / dividend payment.
2.      Growth: to increase the value of the principal amounts through capital appreciation.
3.      Stability: to protect the principal amounts invested from the risk of loss.

Investment objectives depend on the risk taking ability of the risk of loss. Investment selection is the risk return trade off which is affected by the following constraints:

a.      Liquidity / Marketability.
b.      Taxes: Tax shelters should be incorporated while making investment decision.
c.       Times horizon: Long term / Short term.

 

Phase 3: Choice of Assets Mix: From a wide variety of investment avenues generally top priority is accorded to residential house and a suitable insurance cover. In additional, one must maintain a comfortable liquid balance in a convenient form to meet excepted and unexpected expenses in the short run. While choosing the Debt equity mix an investor has to understand the two key factors that have a bearing on the asset mix decision.

a.      Risk tolerance i.e. Risk averse / Risk neutral / Risk seeker.
b.      Investment horizon i.e. Short term / Long term.

 

Phase 4: Formulation of Portfolio Strategy: After choosing a certain asset mix next step is to formulate an appropriate portfolio strategy. Two broad choices are available in this respect, and active portfolio strategy or passive portfolio strategy.

 

1.      Active Portfolio Strategy: An active portfolio strategy is followed by most investment professionals and aggressive investors who strive to earn superior returns after adjustment for risk. It involves aggressive management of portfolio with a view to obtain superior risk adjustment return. The four principal areas of an active strategy are:
a.      Market Timing: In this case according to the market trend forecasts, the portfolios are churned. E.g. if equity stocks are likely to perform better then bond market then the proportions of equity is increased in the portfolio and vice versa. It is obvious that switching from offensive and defensive portfolio is subject to risk.
b.      Sector Rotation: Sector or group rotation may apply to both the stocks based on their assessed outlooks. For e.g. if infrastructure and engineering goods sectors would do well in the forthcoming period then stocks portfolio should be titled more towards these sectors.
c.       Security Selection: Security selection involves a search for under priced securities. If we resort to active stocks selection we may employ fundamental and / or technical analysis to identify stocks which seem to promise superior returns.
d.      Use of Specialization 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. Some of the concept that have been exploited successfully by investment practitioners are;

  • Growth stocks.
  • Technology stocks.
  • Cyclic stocks.

 
2.      Passive Strategy: The passive strategy is based on the premises that the capital market is fairly efficient with respect to the available information. It involves adhering to the following guidelines:
Create a well-diversified portfolio at a predetermine level of risk.

a.      Hold the portfolio relatively unchanged over times, unless it becomes inadequately diversified or inconsistent with the investor’s risk – return preference.

 

Phase 5: Selection of Securities:

 

1.      Selection of fixed incomes avenues(bonds)

An investor should carefully evaluate the following factors in selecting fixed income avenues:

a.      Yield to maturity.
b.      Risk of default.
c.       Tax shield.
d.      Liquidity.
2.      Selection of Stocks: Three broad approaches are employed for the selection of equity shares.a.      Technical analysis: This analysis looks at price behavior and volume data to determine whether the share will move up or down or remain trend less.
b.      Fundamental analysis: Fundamental analysis focuses on fundamental factors like earning level, growth prospect and risk exposure to establish the intrinsic value of a share.
c.       The random selection approach: It is based on the premises that the market is efficient and securities are properly prices.
3.      Selection of Real Estate / Commodities.

 

Phase 6: Portfolio Execution: This step is to implement the portfolio plan by buying and / or selling specified securities in given amounts as planned.

 

Phase 7: Portfolio Revision: Portfolio revision means changing the assets allocation of a portfolio.

Due to dynamic developments in the capital markets and the changes in the circumstance, even a well constructed portfolio tends to become inefficient and hence need to be monitored and revised periodically. This usually entails two things i.e. Portfolio rebalancing and portfolio upgrading.

Portfolio rebalancing: This involves reviewing and revising the portfolio composition / mix i.e. shifting from stocks to bonds or vice-versa. There are three basic policies in portfolio rebalancing.

a.      Buy and hold policy: where no change is effected and portfolio mix of debt equity is allowed to drift.
b.      Constant mix policy: where the desired target proportion of debt and equity is maintained when relative values of debt and equity in the portfolio changes. E.g. if the target debt equity mix was 50:50 portfolio rebalancing is done to maintain this target of 50:50 when any changes takes place in their market values.
c.       Portfolio insurance policy: increasing the exposure to stocks when portfolio appreciates in value and vice- versa.

Portfolio updating: This involves re-assessing the risk-return characteristics of various securities, selling the over – priced securities and buying the under – priced securities. It also entails other change the investor may consider necessary to enhance the performance of the portfolio.

 

Phase 8: Performance Evaluation: The key dimension of portfolio performance evaluation is the rate of return and risk. Also the performance index models are commonly used to evaluated the portfolios.

(a)   Assessment of return: The return of the portfolio can be calculated by applying the Holding period return, Annualized return formulas. In case of intermediate additions the technique of internal rate of return can be applied to find out the return on the portfolio.

(b)   Risks: The risk of a portfolio can be measured in various ways. The two most commonly used measures of risk are variance and beta.

Performance index: The performance index of a portfolio should reflect its risk and return characteristic. The important portfolio performance indexes commonly used to evaluate the portfolio performances are Sharpe, Treynor and Jensen Measure.


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