Portfolio Management. Definition, Characteristics, and Benefits

Portfolio management is the process of managing a portfolio of investments. The term "portfolio" refers to an aggregation of individual securities or other financial instruments, such as stocks and bonds that are held by one entity for investment purposes. Portfolios can be managed in many different ways depending on their size, complexity, risk tolerance, time horizon, etc., but they all share some common characteristics:

Characteristics of a Portfolio


They have a goal.

Portfolio managers seek to achieve specific goals. These goals may include maximizing returns over any given period, achieving certain levels of risk-adjusted performance, maintaining capital growth rates, generating income streams from dividends and interest payments, providing liquidity through the sale of shares at attractive prices, etc.

They contain assets.

A portfolio contains various types of assets including cash, debt obligations, equity interests, and derivatives. A derivative is a contract between two parties where one party agrees to make periodic payments to another based upon specified criteria related to underlying asset values. Derivatives allow investors to manage risks associated with changes in market conditions without having to own actual physical commodities. 


For example, if there were no futures markets available, it would not be possible for an investor to hedge against a price decline in crude oil because he/she could not sell contracts until after the decline occurred. In contrast, futures contracts provide a way to protect against future price movements before those moves occur.

They are composed of multiple components.

 The most basic form of a portfolio consists of only one type of security. However, portfolios often consist of more than just one class of security. Commonly used classes of securities include equities, fixed income, real estate, currencies, commodity futures, options, mutual funds, exchange-traded funds, private placements, structured products, etc.

Each component has its own unique attributes.

 Each component within a portfolio will exhibit different behaviors under changing economic circumstances. Some components will perform well when others do poorly; some will outperform while others lag behind. This means that each component must be analyzed separately to determine how it should best contribute to overall portfolio performance.

Components interact with each other.

Components of a portfolio work together to produce results. When one component performs better than expected, this usually leads to improved performance across the entire portfolio. Conversely, poor performances among several components can lead to losses throughout the portfolio.

Portfolio plan

A portfolio plan describes what you want your portfolio to accomplish. It includes both short-term and long-term objectives. Short-term objectives describe what you expect to happen during the next few months, quarters, years, or decades. Longer-term objectives focus on longer periods of time, e.g., 5–10 years out. You might set up a series of intermediate targets along the way toward reaching these final goals. The following list provides examples of common short-term and long term objectives:

Short Term Objectives:

Maximize return by investing in stocks

Minimize volatility by diversifying investments

Long Term Objective:

Earn $100 per month by selling stock index fund units at retirement age

Diversify risk by holding 10% bonds and 90% stocks

Investment Strategy

An investment strategy defines which instruments you intend to use as part of your portfolio. An effective investment strategy helps ensure that your portfolio meets all of your financial needs over the course of your lifetime. There are many ways to construct an investment strategy. Here are three commonly used approaches:


  • Asset allocation - Determining the mix of different kinds of investments
  • Risk tolerance – Deciding whether to take a greater risk or less risk in order to achieve higher returns
  • Time horizon – Choosing the length of time you wish to invest.


Asset Allocation

There are four main categories of investments:

Equity Investments: These represent an ownership interest in companies. Equity investments typically offer high potential returns but also carry significant risk. Examples include large-cap growth stocks, small-cap value stocks, mid-cap growth stocks, and emerging market stocks.

Fixed Income Investments: Fixed income investments pay regular dividends or coupons. Bonds have lower yields compared to equities, but they tend to be safer since their principal cannot fall in value. They may provide tax advantages for investors who hold them until maturity. Common fixed income securities include U.S. Treasury bills, corporate bonds, municipal bonds, mortgage-backed securities, asset-backed securities, and inflation-protected securities.

Cash Investments: A cash investment is simply money deposited into a bank account. This type of security has no yield, so it does not generate any revenue. However, it offers safety from loss if there is a decline in the overall economy. In addition, cash allows you to avoid taxes when you withdraw funds.

Real Estate Investment: Real estate represents property owned either directly or indirectly through shares of real estate investment trusts. REITs own properties such as shopping centers, office buildings, apartment complexes, hotels, etc. As with other types of assets, real estate can increase or decrease in price depending upon economic conditions.


Benefits of Portfolio Management

Portfolios help protect against unexpected events like job losses, divorce, medical emergencies, and natural disasters. When combined with insurance policies, portfolios allow individuals to meet most of their future financial obligations even after losing their jobs or becoming ill.

  • The benefits of having a well thought out portfolio include:

  • Lower costs due to fewer transactions

  • Higher rates of return because more capital is available for new ventures

  • More options for diversification

  • Greater peace of mind knowing that you will never run short of resources

Frequently Asked Question about Portfolio Management

 How Do I Choose An Asset Class To Include In My Portfolio?

When choosing what kind of investments to put into your portfolio, consider these factors:

Risk/Return Profile

You should choose investments based on how much risk you want to assume versus how much reward you expect to receive. For example, investing in stocks carries some risks including volatility, downside risk, and lack of liquidity. On the other hand, owning a bond provides protection from inflation by locking up your savings at current low-interest rates. The higher the expected rate of return, the greater the risk involved. 

If you are looking for an easy way to make money without taking on too many risks, then you might prefer putting all of your money into one stock fund. Alternatively, if you are willing to take on more risk, you could invest in several different mutual funds which each contain a mix of various kinds of investments.

Tax Advantages

Tax laws vary widely among countries. Some governments offer favorable treatment to certain types of investments while others do not. You need to know whether your country's government imposes special taxation on particular forms of investment. Also, keep in mind that holding foreign currency-denominated debt instruments may give rise to additional tax liabilities.

Liquidity

If you plan to sell off part of your holdings quickly, you'll probably find it easier to liquidate your investments than to buy back in later. Liquidity refers to the ease with which you can convert your asset into cash. It also includes the speed with which you can get rid of them. High-quality securities tend to have lower levels of liquidity since they require longer periods before being converted into cash. Low-quality securities usually trade infrequently and carry high transaction fees.

Costs

Costs associated with buying and selling securities affect both the amount of time required to complete trades and the total cost of ownership. Fees charged by brokers add to the overall expense of trading. Brokers charge commissions when you purchase shares as well as when you sell them. These charges typically range between 0% and 1%. However, there are times when you pay no commission at all. 

This occurs when you use margin accounts. Margin allows investors to borrow money to finance purchases. They must deposit enough collateral to cover any potential loss. Once borrowed, this money becomes "locked" until the investor sells his position.

When he does so, the broker returns the loan plus interest.

The Bottom Line

Portfolio management is about making sure that you're getting the best possible combination of risk and reward. By considering the above points, you will be able to select appropriate investments for your needs.