What is portfolio management?
Definition
Portfolio Management involves the skillful and systematic selection and supervision of a set of investments that align with the financial goals and risk preferences of a client, business, or organization over an extended period of time.
Understanding Portfolio Management
Portfolio managers, whether professional or individual, aim to maximize the expected return of investments while managing risks. They evaluate different investment options, considering factors such as debt vs. equity, domestic vs. international, and growth vs. safety. Portfolio management involves making trade-offs among these options to create a diversified portfolio that balances risk and return.
Portfolio management can be either passive or active. Passive management involves creating a portfolio that mirrors a market index, such as the S&P 500, while active management involves actively making investment decisions to try to outperform the market.
Passive management is a long-term strategy that requires minimal intervention. It involves investing in one or more exchange-traded funds (ETFs) that track an index. This strategy is also known as index investing and is often based on modern portfolio theory (MPT) to determine the optimal mix of investments.
Active management, on the other hand, involves trying to outperform an index by actively buying and selling individual stocks and other assets. Closed-end funds are typically actively managed, and active managers may use quantitative or qualitative models to evaluate potential investments.
Key Elements of Portfolio Management
Asset Allocation
The crucial element in successful portfolio management is the proper balance of assets over the long-term. Typically, this involves a combination of stocks, bonds, and cash equivalents like certificates of deposit. There are also other options, known as alternative investments, such as real estate, commodities, and derivatives.
Asset allocation is based on the idea that different asset types do not always move in the same direction and some carry more risk than others. By diversifying holdings, individuals can achieve balance and mitigate risk.
Those with a more risk-tolerant approach may opt for a portfolio weighted towards growth stocks, while individuals with a more conservative stance may prefer stable investments like bonds and blue-chip stocks.
Diversification
Investing is unpredictable and it's impossible to consistently predict which investments will succeed or fail. It's wise to create a portfolio of investments that offer broad exposure within a particular asset class. Diversification means distributing the risk and reward of individual securities within an asset class or between asset classes. It aims to capture the returns of all sectors over time while minimizing volatility. True diversification involves investing in different types of securities, economic sectors, and geographic regions.
Rebalancing
Rebalancing is a technique used to maintain a portfolio's desired asset allocation by periodically realigning it back to its original target. This is done typically once a year to restore the original asset mix, which may have drifted off course due to market movements. For instance, if a portfolio starts with a 70% allocation in equities and a 30% allocation in fixed-income, it could shift to an 80/20 allocation after a prolonged market rally. This means that the portfolio now carries more risk than the investor can tolerate, even though the investor made a good profit. Rebalancing involves selling overpriced securities and investing that money in undervalued securities that are out of favor. By rebalancing annually, investors can realize gains and expand growth opportunities in high-potential sectors while keeping the portfolio in line with the original risk and return profile.
Active Portfolio Management
Investors who choose active management work with fund managers or brokers to buy and sell stocks, with the goal of achieving better returns than a particular index, such as the S&P 500 or Russell 1000. Active investment funds have individual portfolio managers or management teams making investment decisions based on in-depth research, market forecasting, and expertise. These managers pay close attention to market trends, shifts in the economy, political changes, and company news to time the purchase or sale of investments, aiming to take advantage of market irregularities. The added market risk of trying to beat the market is a factor that active managers must consider. In contrast, indexing eliminates this risk as there is no human error in stock selection. Additionally, index funds are traded less frequently, resulting in lower expense ratios and greater tax efficiency compared to actively managed funds.
Passive Portfolio Management
Passive portfolio management, which is also known as index fund management, strives to replicate the performance of a specific market index or benchmark. This is achieved by purchasing the same stocks listed on the index and assigning them the same weighting as represented in the index. Passive strategies can be implemented through exchange-traded funds (ETFs), mutual funds, or unit investment trusts. Index funds are considered passive because the portfolio manager's role is to mirror the index rather than choose which assets to buy or sell. Compared to active management approaches, passive portfolios or funds usually have lower management fees.
Gist
Portfolio management entails creating and supervising a collection of investments that align with an investor's risk tolerance and long-term financial objectives.
Active portfolio management involves buying and selling stocks and other assets strategically to outperform the overall market, while passive portfolio management aims to replicate the composition of a specific index or indices to achieve market returns.