To give yourself the best chance at success when it comes to your investments, consider implementing a portfolio management approach. Portfolio management is a system adopted by many financial advisors that takes numerous variables into account for your investments. The process can help you stay on the right track when it comes to your goals, and gives you an opportunity to systematically diminish the risk in your portfolio. It’s also a good method to turn to when you feel like your investment portfolio needs help. So, what is portfolio management? Here’s a detailed look at what you need to know.
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If you feel like jumping ahead to learn more about portfolio management, click one of these links:
- Portfolio Management Definition
- The Portfolio Management Process
- Other Aspects of Portfolio Management
- Diversifying Risk
- What’s the Bottom Line?
Portfolio Management Definition
Portfolio management involves creating an investment strategy to meet specific financial goals. It incorporates such disparate elements as asset allocation, risk assessment, ongoing analysis and rebalancing.
The Portfolio Management Process
As a process, portfolio management incorporates several steps. Below are the three key ingredients of portfolio management.
Goals, otherwise known as investment objectives, are probably the most important elements of the portfolio management process. Your goals define what you’re trying to accomplish with your investments and will immediately steer you toward or away from certain investment options. For example, if your investment objective is aggressive growth, the portfolio management process will keep you away from conservative, low-risk/low-return investments like U.S. Treasury bills. Investment objectives are often broadly classified into categories such as aggressive growth, growth with income or income with capital preservation. Your goals will help you find the best possible risk-adjusted return on investment.
Your timeline is also an important factor in the portfolio management process, as it defines the length of time you desire to achieve your investment objectives. The longer your timeline, the more risk you can take with your portfolio, so it’s important to make this determination. If your savings goals are only six months down the road, for example, you won’t want to own too many aggressive investments because you’ll only have a short period of time to recoup any losses you might suffer.
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Risk assessment is the final element of the three-legged stool that is portfolio management. Generally speaking, the riskier the investment, the higher the return potential. However, not all investors can handle portfolios that are high-risk, which is why it’s important to assess your risk tolerance. If your portfolio is too risky you might have trouble sleeping at night due to stress from your investments. A risky portfolio is also more susceptible to large drops in value, which can be unsettling at best and damaging to your long-term investment success at worst. Defining the appropriate risk-return profile for your portfolio gives you peace of mind regarding your investments and assures that the risk and reward elements of your portfolio are in balance.
Other Aspects of Portfolio Management
Although goals, timeline and risk assessment are the three primary drivers of portfolio management, subcategories of these pillars are equally important.
Determining an Appropriate Asset Allocation
Asset allocation refers to the process of choosing the types of investments you’re going to own. Asset allocation relies on the principle that not all investments move in the same direction, with the same speed, at the same time. For example, if stocks sell off sharply, bonds often rally in price. By owning a diverse collection of assets, you can reduce the overall risk of your portfolio.
Your investment goals and risk tolerance are important factors to help determine your most appropriate mix of assets. Modern portfolio theory, which aims to maximize returns for a given level or risk, can also be integrated into your portfolio management to help you optimize your investments.
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Choosing a Passive or Active Investment Style
Once you’ve figured out where you’re going, you’ll have to decide how to get there. There are two broad options when it comes to investment management styles: active or passive. Active portfolio management refers to the more traditional form of management, in which investors actively buy and sell securities in an effort to outperform their given benchmarks, such as the overall stock market. Discretionary portfolio management takes this a step further, with professional money managers who are given the authority to make buy-and-sell decisions on behalf of an individual investor. Passive management refers to using indexes that simply mirror the performance of another group of investments.
Both investment styles have their pros and cons. With passive investment, you’re always guaranteed to get the return of the underlying index, minus whatever management fees or commissions are involved. With active management, you may either outperform or underperform your chosen investment target, based on the success of either your hired manager or your own investment selections.
Intuitively, it might seem like active management makes more sense. After all, who wouldn’t want to try to get the absolute maximum return possible by trying to incorporate all available information? Unfortunately, most active managers don’t outperform the indexes they’re attempting to top. In 2018, for example, 64.49% of large-cap funds underperformed the S&P 500 — the ninth year in a row that the majority of large-cap funds underperformed the S&P 500. Chasing performance might be even worse. According to S&P Global Indices, only 2.33% of domestic equity funds that were in the top quartile as of March 2016 managed to stay in the top quartile at the end of March 2018 — an incredible statistic.
Of course, passive management isn’t without its own drawbacks. If you’re simply tracking an index, you’ll never outperform it — and in most cases, you’ll trail it since there are expenses involved in investing.
For this and other reasons, many investors consider a blend of active and passive investment strategies to be the smartest investment strategy when setting up a portfolio.
Rebalancing the Portfolio
Once you’ve created an optimal asset allocation based on your investment objectives, risk tolerance, time horizon and investment style, your work isn’t finished. Portfolio management is about more than creating a basket of investments. The investment landscape and your own personal financial situation are always changing, so you’ll have to monitor your investments on an ongoing basis. From time to time, you’ll inevitably have to make changes to your portfolio, either to keep it in balance with your original asset allocation or to update it to match the changes in your own goals.
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To help illustrate why rebalancing is important, consider this example. Imagine that your portfolio was mainly conservative but had a 20% allocation to aggressive growth stocks. During a boom period for the stock market, let’s say this portion of your portfolio doubles and now comprises 40% of your assets. While it’s great that you’ve generated a huge gain, your portfolio is now far riskier than what your original asset allocation suggests. Your portfolio is now overweighted in these aggressive stocks and will be more volatile than you might be prepared for. Rebalancing your portfolio by trimming back the portions that have grown too large and adding the proceeds to the underallocated portions will get your investments back in line with your asset allocation and risk tolerance.
One of the drawbacks of investing is taxation. Portfolio management incorporates tax minimization strategies to avoid the drag on investment returns caused by taxation. If you earn a 20% gain but have to pay a 30% tax, for example, your net return drops to just 14%. Portfolio management can utilize strategies such as offsetting gains and losses to reduce your tax drag to as close to zero as possible — a process known as tax-loss harvesting — thereby improving your long-term net return.
Risk in all financial markets is a reality. Although the long-term trend of the stock market has always been up, there have been plenty of vicious selloffs along the way. During the global financial crisis of 2008-09, an all-stock portfolio lost nearly half its value. However, a more diversified portfolio lost only 35% of its value. While that’s still a large number, it’s significantly less than 50%. The truth is diversification cannot protect you from a loss, but it can help protect you from major drawdowns. Over the long run, the purpose of a diversified portfolio is to smooth out the ups and downs of a portfolio while providing the best possible return for a given level of risk. If you plan on managing your stock portfolio yourself, portfolio management can help you achieve these goals.
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What’s the Bottom Line?
At the end of the day, portfolio management is a system that serves two main purposes: It can help you model the most appropriate portfolio and provide you with rules to help keep that portfolio in balance. Investing can be an emotional endeavor — both on the upside and the downside. Having a written portfolio strategy in place can help you stay on course during tumultuous times.
When the market is heading straight up it’s easy to think that things will stay that way forever. Similarly, when stocks sell off sharply, many investors panic and want to abandon their stock allocations. In both of these scenarios, asset allocations get out of whack and portfolios suffer if they are not rebalanced. A written investment strategy that implements portfolio management can help prevent these types of situations.
At the very least, going through the portfolio management process can help you articulate your investment objectives, timeline and risk tolerance so that you understand your needs and temperament as an investor. Similarly, working with one of GOBankingRates’ best brokers can help steer you in the right direction.
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Last updated: May 25, 2021