What are the Principles of Portfolio Construction?

PRINCIPLES OF PORTFOLIO CONSTRUCTION :
The portfolio manager has to follow certain principles while constructing a portfolio. These
principles are as follows :
(1) Safety Principle : 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
a rising 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 of the portfolio in common stock.
(2) 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
the portfolio must provide based on current conditions. This involves determining a
family budget that is consistent with the standard 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 provide a stream of income from a securities
portfolio that offsets it, as well as possible.
(3) Taxation : There may be strong incentive 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.
(4) 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. Some investors are able to
accept risk. Common stock prices are volatile. Investors who find these volatility
disturbing, may not have the temperament for common stock investment.
Temperament may be the overriding constraint in arriving at an appropriate portfolio
policy for the investor.