CONSTRUCTION OF PORTFOLIO : Portfolio construction means determining the actual
composition of portfolio. It refers to the allocation of funds among a variety of financial
assets open for investment.
Portfolio theory concerns itself with the principles governing such allocation. Therefore, the
objective of the theory is to elaborate the principles in which the risk can be minimised
subject to a desired level of return on the portfolio or maximise the return subject to the
constraints of a certain level of risk. The portfolio manager has to set out all the alternative
investments along with their projected return and risk and choose investments which
satisfy the requirements of the investor and cater to his preferences.
It is a critical stage because asset mix is the single most determinant of portfolio
performance. Portfolio construction requires a knowledge of the different aspects of
securities. The components of portfolio construction are
(a) Asset allocation
(b) Security selection and
(c) Portfolio structure.
Asset allocation means setting the asset mix. Security selection involves choosing the
appropriate security to meet the portfolio targets and portfolio structure involves setting the
amount of each security to be included in the portfolio.
Investing in securities presupposes risk. A common way of reducing risk is to follow the
principle of diversification. Diversification is investing in a number of different securities
rather than concentrating in one or two securities. The diversification assures the benefit of
obtaining the anticipated return on the portfolio of securities. In a diversified portfolio, some
securities may not perform as expected but other securities may exceed expectations with
the effect that the actual results of the portfolio will be reasonably close to the anticipated
results.
What is Portfolio Construction?
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