Major Activities in Portfolio Management
Portfolio management is also known as investment management which consists of managing
the investment securities options. There are seven main activities in portfolio
management. They are:
- Laying down the objectives of investment and the difficulties involved in it
- Choosing the asset mix
- Portfolio strategy formulation
- Securities selection
- Execution of portfolio
- Revision of portfolio and
- Evaluation of performance.
- Laying down the objectives of investment and the difficulties involved in it
The two main objectives of any investment would be the expectation regarding returns and the ability of the investor to assume a level of risk. Investors would aim to achieve a steady income involving growth and higher returns. Risk levels could be conservative, moderate or aggressive. Risk and returns are directly related. More the risk, the more would be the returns and lower the risk, lower would be the returns. The difficulties or constraints in laying down the objectives of investment could be related to liquidity requirements of the investor, investment horizon, post-tax returns, law and regulations of the country and his personal circumstances. - Choosing the asset mix
The second activity in portfolio management is to decide the proportion of the various asset categories in the investor’s portfolio. The various asset categories include bonds and debentures, stocks, cash investments, precious metals like gold and silver, investment in real estate etc. Investments are aimed at various purposes like education to build human capital, purchase of house, meeting medical & sustaining expenses etc. The choice of proper asset mix will be based upon the expectation of returns and the risk perception of the investor. - Portfolio strategy formulation
After the choice of asset mix is done, the next step for the investor is to formulate a portfolio strategy. Active portfolio strategy and passive portfolio strategy are the two broad choices that are available to formulate. An active portfolio strategy involves professionals in investments and investors who are aggressive to get higher returns and earnings. Passive portfolio strategy involves creating a well-diversified portfolio, the risk of which is pre-determined and holding the portfolio unaltered over a period of time. - Securities selection
The selection of debt securities like debentures and bonds have to be evaluated considering the factors like yield to maturity, default risk, tax shield and liquidity. The selection of equity shares involves technical, fundamental and random analysis. These analyses are aimed at price behavior, volume of trading, trend, level of earnings, growth prospects, risk exposure, prevailing stock price etc. - Execution of portfolio
After the formulation of investment objectives, choosing asset mix, formulating portfolio strategy and selection of securities, the portfolio has to be executed by buying or selling transactions or both. A proper understanding and knowledge of trading game, trade motivation, nature of key players in the market, likely losers and winners etc. will aid in this respect. - Revision of portfolio
The portfolio thus executed after formulation has to be reviewed and monitored periodically. This is essential because the risk-return levels of the various securities in the portfolio would have altered over time, the objectives of the investor would have changed, risk perception of the investor would have changed and the targets would have drifted away. The revision of portfolio involves portfolio re-balancing and portfolio upgrading. - Evaluation of performance
The evaluation of performance is with respect to the rate of return and risk. It involves measuring the returns generated, risk adhered to and the overall performance of the portfolio.
Measuring the rate of return:
The rate of return from a portfolio for a given period, say one year can be measured
as follows:
Rate of return | = |
Dividend Income + Terminal Value – Initial value
Initial value |
x | 100 |
Example:
Let us calculate the rate of return of a portfolio with the following values:
Initial market value of the portfolio = $100,000
Dividend and interest income received till the end of the year = $15,000
Terminal market value of the portfolio = $102,000
There are also other measures of calculating returns like arithmetic average measure, internal rate of return measure etc.
Measuring the risk:
The measures of risk that are most widely and commonly used are variability and beta measures. The preferred measure of variability is standard deviation and beta reflects the systematic risk of the portfolio.
Measuring the overall performance
Measuring the performance of the portfolio involves considering both risk and return. The most widely used measures of performance are Treynor’s measure, the Sharpe measure, the Jensen measure and the M2 measure.
Where: rp* = return on adjusted portfolio whose volatility matches the volatility of the market index and rM = return on the market index.
The above are the various activities in portfolio management.
Initial market value of the portfolio = $100,000
Dividend and interest income received till the end of the year = $15,000
Terminal market value of the portfolio = $102,000
Rate of return | = |
($15,000 + $102,000 - $100,000)
$100,000 |
x | 100 |
=> | 17% |
There are also other measures of calculating returns like arithmetic average measure, internal rate of return measure etc.
Measuring the risk:
The measures of risk that are most widely and commonly used are variability and beta measures. The preferred measure of variability is standard deviation and beta reflects the systematic risk of the portfolio.
Measuring the overall performance
Measuring the performance of the portfolio involves considering both risk and return. The most widely used measures of performance are Treynor’s measure, the Sharpe measure, the Jensen measure and the M2 measure.
Treynor's measure => |
Excess return on portfolio p
Beta of portfolio p |
Sharpe's measure => |
(Average rate of return on portfolio p – Average rate of return on a risk free investment)
Standard deviation of return of portfolio p |
Jensen's measure => | Average return on portfolio p – [Risk-free return + Portfolio Beta (Average return on market portfolio – Risk free return)] |
M2 Measure => | M2 = rp* - rM |
Where: rp* = return on adjusted portfolio whose volatility matches the volatility of the market index and rM = return on the market index.
The above are the various activities in portfolio management.
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