Portfolio Management And Diversification Essay Research Paper

PORTFOLIO MANAGEMENT AND DIVERSIFICATION

Introduction:

Portfolio management is a conglomeration of securities as whole, rather than unrelated individual holdings. Portfolio management stresses the selection of securities for inclusion in the portfolio based on that security’s contribution to the portfolio as a whole. This purposes that there some synergy or some interaction among the securities results in the total portfolio effect being something more than the sum of its parts. When the securities are combined in a portfolio, the return on the portfolio will be an average of the returns of the securities in the portfolio. For example, if a portfolio was comprised on equal positions in two securities, whose returns are 15% and 20%, the return on the portfolio, will the average of the returns of the two securities in the portfolio, or 17.5%. From this we will discuss the process of creating a diversified portfolio. The diversified portfolio is a theory of investing that reduces the risk of losing all your money when “all your eggs” are not in one basket. Diversification limits your risk an over the long run, can improve your total returns. This is achieved by putting assets in several categories of investments.

Portfolio Process:

The portfolio process is as follows:

1. Designing an investment objective;

2. Developing and implementing an asset mix;

3. Monitoring the economy and the markets;

4. Adjusting the portfolio and measuring the performance

Due to the intensity of each of the four items, we will be covering only the first two.

1. Investment Objective:

This topic is broad and contains three major divisions. They are foundation objectives, constraints and major objectives.

Foundation Objectives: These objectives generally receive the most attention from investors and are determined by thorough determination of your needs, preferences and resources.

 Return – you need to determine whether you prefer a strategy of return maximization, where assets are invested to make the greatest return possible while staying within the risk tolerance level, or whether a required minimum return with certainty is preferable, generating only as much return with emphasis on risk reduction.

 Risk – There are many ways to assess the risk tolerance of any particular investor, from the least knowledgeable of investments to the very sophisticated investor. Besides the risk you are willing to take, there must be a measure of the risk associated with each security be considered for the inclusion in the portfolio. It is important to recognize the difference between the risk of an individual security and the risk of the portfolio as a whole. The risk of a portfolio is less than the average risk of its holdings, your risk tolerance should be matched to the risk of the overall portfolio and not to the risk of each security.

 Inflation – Although some degree of inflation protection is needed, the extent will vary depending upon the time horizon and the goal of using the portfolio to generate income for future cash consideration. Whereas, someone using a short term trading strategy and interested in maximization of capital gains may concentrate less on this factor.

 Time Horizon – The time horizon is the period of time from the present until the next major change in your circumstances. A good portfolio design will reflect this time change. For example – at 25 years of age and normal retirement at age 60 does not necessarily mean the time horizon is 35 years. Different events in your life can represent the end of one time horizon and the beginning of a new time horizon and a need for a complete rebalancing of your portfolio. These events could include finishing university, purchase of a new home and many others beside retirement.

 Liquidity – In portfolio management this is the amount of cash and near-cash in the portfolio. For liquidity purposes, if you are wealthy and risk tolerant you may choice to have about 5% of your portfolio in cash, this does mean that the cash component will never rise above 5% due to the market cycle. Whereas those who are risk adverse may choice to have 10% or more in cash.

 Taxation – The level of taxation will determine the choices that are made in regards to the choice of tax advantaged securities such as some limited partnerships as well as the choice of tax deferral plans.

 Market timing – Your investment strategy could include the buy and hold approach or the market timing approach of investment. Buy and hold means long holding periods through various market cycles for long-term growth and income. Market timing involves timing the short term entry and exit points in the market in pursuit of quick trading, gains over and above the commissions incurred.

There are some other reasons why a portfolio foundation objective maybe determined. They could include the desire to retire at a certain age, acquisition of a business, a vacation property, or the pursuit of some other tangible goal.

Constraint Objectives: The constraints provide boundaries that may hinder or prevent you from satisfying your foundation or major objectives.

 Legal – Any investment activity which disregards any act, by-law, regulation, rule or the criminal code must be considered a constraint. For example if your not married you are restricted from participating in a spousal RRSP and therefore from its benefits of income splitting.

 Moral/Ethical – When considering investment activities, your research should include whether the company that you are investing in follows your moral guidelines. For example, if you have personal convictions against alcohol or tobacco usage, then you would not invest in these securities.

 Basic Minimum Income – Your portfolio should be structured to generate a good total return that is required to meet your financial needs and also cover any tax implications, without eroding the value of your portfolio.

 Realism – You need to be realistic in your determining the return that can be provided by your portfolio.

By knowing your constraints of investing, this will assist in developing a portfolio that suits your needs.

Major Objectives: The three major objectives outlined below will assist you in determining the appropriate asset allocation for your portfolio.

 Preservation of Capital – If one of your major strategies is preserving your initial capital investment, this can be achieved by investing in securities that are considered risk free and which will mature in one years time – restoring your principal amount. For example you have an account size of $100,000 and current T-bill rates of approx. 7%, roughly $93,000 can be invested in T-Bills, which are consider risk free. The other $7,000 can be invested in some other venture, even a speculative one, and even if the full $7,000 is lost you will have maintained your principal amount.

 Income – Refers to the regular series of cash flows from a portfolio, whether it is in the form of dividends or interest. Return, risk and inflation influence income.

 Capital Gains – Refers to increases in capital due to sales proceeds being higher than cost bases. The emphasis here is on the security selection and market timing, and generally is a trade off against preservation of capital. Capital gains are taxed more favourably than interest income, which also provides some incentive for this objective over income.

It is important to understand these major objectives, so that you can reach an appropriate balance among the three.

Asset Allocation: Along with the design of your investment portfolio, you need to determine the broad categories from which investments will be selected. The usual main asset classes are cash, fixed income and equity securities. More sophisticated portfolios may also include an international and derivatives asset class. We will provide basic descriptions of each of the asset classes excluding international and derivative asset classes.

 Cash – Includes currency, money market securities, Canada Savings Bonds, GIC’s, bonds with maturity of one year or less, and all other cash equivalents. All cash and cash equivalents are primarily used for liquidity purposes. As stated before, cash usually makes up at least five percent of a diversified portfolio’s asset mix. The risk adverse may also hold as much as ten percent in cash.

 Fixed Income – The asset class consists of bonds due in more than one-year, strip bonds, mortgages, private placements and other debt instruments, and preferred shares but not convertible securities due to their risk. Their purpose is to primarily produce income with some safety of principal, although they also used for capital gains generation. Preferred shares are included in this asset class because of their price action and cash flow characteristics. To achieve diversification in this asset class several components of fixed income can used. For example government and corporate bonds with a range of credit qualities from AAA to lower grades and foreign bonds maybe added to domestic holdings. As well as, there can a variety of terms to maturity, or durations used. The amount of a portfolio allocated to fixed income securities is governed by several factors:

 The need for income over capital gains

 The basic minimum income required

 The desire for preservation of capital

 Other factors such as tax and time horizon

Fixed income generally accounts for at least 15% of a diversified portfolio, and under special circumstances may be as much as 95% of a portfolio.

 Equities – There are several different types of securities included in this asset class. The following are just a few of such securities: common shares, rights, warrants and options. The main purpose of this asset class is generate capital gains either through active trading or long term growth in value. There will also be cash from this section due to a dividend stream. The objectives and constraints that will have influence in this asset class are risk, return, time horizon and inflation to name a few. This account may also account for 15% to 95% of a diversified portfolio.

2. Asset Mix:

The next step in the asset allocation process to determine the appropriate balance among the selected asset classes. To determine the appropriate asset mix you must know who you are and what you want out of your investment. A different mix would occur if you were young professional, a middle aged factory worker or a senior citizen. For example:

 Young, single professional with medium investment, high risk tolerance and long time horizon may choose the following asset mix:

Cash 5%

Fixed Income 25%

Equities 70%

 Middle-aged factory worker, married, three children. With concerns about future employment and funding college education, with low investment knowledge and medium risk tolerance may choice the following asset mix:

Cash 10%

Fixed Income 40%

Equities 50%

 Senior citizen with no income other than government pension, with medium time horizon and low risk tolerance may choice the following asset mix:

Cash 8%

Fixed Income 62%

Equities 30%

When creating your diversified portfolio it will need to be constructed within your own particular risk guidelines. Therefore it is important to manage risk within your portfolio. When managing risk there two types of risk to be cognizant of, they are:

 Systematic or market risk – This risk pertains to each capital market, which can be volatile. Therefore, when the stock market averages fall, most individual stocks fall and when interest rates rise nearly all-individual bonds and preferred shares fall in value. Systematic risk can not be diversified away; the more a portfolio becomes diversified, the more it ends up mirroring the market.

 Nonsystematic or security specific risk – This risk pertains to the risk that the price of a specific security or a specific group of securities will change in price to a different degree or in a different direction from the market as a whole. Diversifying among a number of securities can reduce nonsystematic risk.

Both of these types of risk can be avoided when you correctly evaluate your risk guidelines and determine the maximum amount of risk that you are willing to handle.

Conclusion:

Once your portfolio has been established then next step in the management is to evaluate your portfolio’s performance. The success of your portfolio is determined by comparing the total rate of return of the portfolio to the average total return of comparable portfolios. It is essential to develop a system to monitor the appropriateness of the securities that comprise the portfolio and the strategies governing it. The process is twofold as it involves monitoring:

 The changes in your goals, financial position and preferences;

 Expectations in capital markets and individual companies;

Remember that diversification is more than placing your eggs in different baskets. It is also making sure that all your baskets aren’t made from the same material.

Bibliography

References:

Wall Street 101, www.familyinternet.com

Learning to Invest, www.learningtoinvest.com

Your Money Coach, www.yourmoneycoach.com