PRINCIPLES OF PORTFOLIO CONSTRUCTION:
The portfolio manager has to follow certain principles while constructing a portfolio. These principles are as follows:
- SAFETY PRINCIPLES: The safety principle means that the portfolio must maintain its principal value in the event of forced liquidation. Normally, the investor does not want to accept a loss of principal amount of investment. There are two important considerations involved in determining the need for safety principal – tenure of ownership and the effect of inflation. If the tenure of ownership is weak, the portfolio may be liquidated to meet some contingencies. Another consideration is the effect of arising price level on the principal invested initially in the portfolio. For this purpose, many portfolio managers attempt to hedge against inflation by including at least a portion in common stock.
- NEED FOR INCOME: In formulating the objective for a portfolio the starting point is usually to establish an amount of income the portfolio must generate. This involves two stages, in the first stage it is necessary to determine the amount of income that a portfolio must provide based on current conditions. This involves determining a family budget that is consistent with the standards of living desired and then determining whether there are other sources of income in addition to the proposed portfolio of securities. The second stage is to determine how much income must be provided by the portfolio of securities. As inflation is a fact of life, it is necessary to estimate its impact and attempt to provided stream of income from a securities portfolio that offsets it, as well as possible.
- TAXATION: There may be strong incentives for many investors in the high tax brackets to invest in tax exempt securities rather than common stock. It offers investors to combine a high effective yield with relatively low risk. Those investors who qualify tax-exempt securities may constitute a worthwhile investment.
- TEMPERAMENT: A higher return may be expected from a well-diversified portfolio of common stock than a portfolio of bonds, some investors may not be willing to accept the greater risk associated with common stock. Thus temperament is the most important principle on the formulation of portfolio objectives. It indicates the investor’s willingness to accept risk. Common stock prices are volatility disturbing, may not have the common stock temperament. Temperament may be the overriding constraint in arriving at an appropriate portfolio policy for the investor.