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| Portfolio management meaning and approaches |
The term Portfolio is a group of financial assets such as shares, stocks, bonds, debt instruments, mutual funds, cash equivalents, etc. A portfolio is planned in such a way that it stabilizes the risk of non-performance of various pools of investment.
The term Management is the organization and coordination of the activities of an enterprise in accordance with well-defined policies and in the achievement of its pre-defined objectives.
Thus, Portfolio Management guides the investor in a method of selecting the best available securities that will provide the expected rate of return for any given degree of risk and also to reduce the risks. It is a tactful skill of making decisions regarding investment mix and policy which must match the objective of the investors requiring asset allocation to balance the risk.
Approaches to Portfolio Management:
Commonly there are two approaches for portfolio management:-
i. Traditional approach.
ii. Modern approach (Markowitz efficient frontier approach).
The above two approaches are explained below:
i. Traditional Approach:
It basically deals with two major decisions viz., determining the objectives of the portfolio and selection of securities. The need of a rational investor is concerned all about income generation and capital appreciation. The traditional approach describes the appropriate level of which is to be selected to meet the investors’ needs. The traditional approach is carried out in the following steps:
a) Analysis of constraints
b) Determination of objectives
c) Selection of portfolio
d) Assessment of risk and return
e) Diversification
The above steps are explained below:a) Analysis of constraints:
Before investing in any portfolio the investor must first analyze the problems that may be faced by any investor. The constraints may be Income of the investor, Liquidity concern, stability, and tax savings, etc.
b) Determination of objectives:
The investor must determine their objectives before investing in any portfolio. Their objectives may be Profit motive, Capital appreciation, Asset creation, Life safeguard etc.
c) Selection of the portfolio:
The selection of the portfolio depends upon the objectives set by the investors. The investors may be moderate, aggressive and their selection of portfolios will depend upon them.
d) Risk and return analysis:
In the traditional approach to portfolio, the individuals prefer larger to smaller returns from securities. To achieve these goals the investors have to take more risk. The ability to achieve higher returns is dependent upon his ability to judge risk and his ability to take a specific risk. The risk may be interest rate risk, purchasing power risk, financial risk, and market risk.
e) Diversification:
Once the asset mix is determined and risk and return are analyzed, the final step is the diversification of the portfolio. Instead of investing in only one portfolio, an investor must invest in different portfolios. So that the risk differs from one another. In case if the investor faces loss in any portfolio then due to the diversification of investment the investor may be profitable from the other portfolios.
ii. Modern approach (Markowitz efficient frontier approach): The modern approach was pioneered by Harry Markowitz. It is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.
UNDERSTANDING THE STEPS WITH AN EXAMPLE
Mr. A is assertive investors whose annual saving is Rs.2,00,000. He wants to invest his saving in different financial instruments, his main investment motive is regular income i.e. dividend as well as capital appreciation in the medium to long term. Mr. A set some objectives before the investment these are capital appreciation in the medium term, earning dividend i.e. regular income. He also set the objective of safety at a given level of risk, liquidity of the investors is one of the another objective of Mr. A because many investors fail to take into account or understand the liquidity factor and as a result, their financial plans fail
Mr. A invests his saving in such a way that all objectives he set should be fulfilled. His portfolio consists of equity shares, short term money market instruments, bonds, foreign investment, and property. He invests 50% of his saving in equity shares i.e. 1,00,000 of his total saving. 30% investment in the money market this is commercial paper, certificate of deposit, etc. 30% of his saving in bonds, 30% in foreign capital, and 10% in property consisting gold.
He invests half of his saving in equity because its return is not constant it gives higher return as well as also the risk of getting loss of money generally equity shares gives higher rate of return as compared to fixed interest-bearing securities. The money market and bonds give him a fixed rate of return that helps him to maintain liquidity. Foreign investment helps in tax incentives but it is also carries high risk and property helps in capital appreciation because its price goes higher with time.
If Mr. A faces any loss from equity then fixed interest bearing securities and property helps him recover those losses and if equity gives a higher rate of return then Mr. A gets a good amount of return. And also equity and property helped him in getting capital appreciation.
For analyzing risk and return we have considered only one type of Investment i.e. Equity
With the help of the above Risk and Return table, it can be concluded that Mr. A should select either P Company shares or R company shares or both of them because for the same level of risk P gives higher return and for the same level of return Equity R has lower risk.
Mr. A should never be static and sit cool after investing. He should consider shares of different companies belonging to a different sectors. Similarly, the same diversification applies to all categories of investment. If his present portfolio does not seem to combat his set objective, diversification is the only answer to meet his dream.
ConclusionThe Investment market is variably affected. It’s never the same. An aggressive and assertive investor has high potentiality of making money from the market if he/she is the keen observer of the market. The volatile movement of the market hides earning potentiality in it. So, the traditional method systematically prescribes advices to tackle the market potentiality.
