Everyone is more or less familiar with the term ‘investment portfolio’. But have you ever wondered why a strong portfolio is necessary? What goes into building one?
A well-balanced portfolio minimises your risk. A loss in one asset may be off-set by the gain in another. It also grows in value to shield you from the loss of spending power due to inflation, as it includes assets that tend to increase in actual value over time.
A good portfolio also improves your liquidity. It comprises investments that can be easily liquidated, making it possible to access sufficient funds quickly in time of need. It may also facilitate tax savings by allowing you to invest in places that provide tax relief in terms of deductions and exemptions, lowering your overall tax liability.
The security and growth of your investments must be evaluated and managed at timely intervals. Let us categorically break down portfolio management for you.
Portfolio Management strategies are often variable. However, we may divide them into the following four categories:
a) Active Portfolio Management
This type of portfolio management necessitates a high degree of market knowledge. If you are an active trader with a high risk threshold, this technique is for you. A portfolio manager using an active strategy seeks to outperform the market in terms of returns. The plan involves rigorous market analysis and extensive diversification. You must also have a solid grasp of the business cycle. The most significant advantage of active methods is exceeding the market expectation while gaining excellent returns.
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b) Passive Portfolio Management
The proponents of passive portfolio management believe in the efficient market theory, hence it isn’t concerned with ‘winning the market.’ They think fundamentals would always be mirrored in the underlying asset’s value. If you are an investor who is looking to minimise risk, this strategy will suit you best. The risk quotient is lower as investment is done for the long-term, in line with the underlying benchmark index. Another major advantage of passive investing is that it is the least expensive option to deploy. There is no frequent buying and selling, instead you just sit out and hold your investment as it gains value over the years. Making quality picks becomes imperative here.
c) Discretionary Portfolio Management
If you wish to invest in the market but do not have enough time to spare, you can still do so using a discretionary strategy. There may also be cases where you are not fully aware of the market conditions to make the correct investing decisions. But using this portfolio management strategy, you can benefit from the knowledge of the experts. The portfolio manager has entire control over their client’s investment decisions. The manager makes both purchase and sale choices on your behalf and employs whichever approach they believe is optimal. This sort of plan can only be provided by persons with substantial financial expertise and experience. All you have to do is provide the amount you wish to invest and the details of your risk profile and your financial goals. Trust in the abilities of the portfolio manager plays an important role.
d) Non-Discretionary Portfolio Management
This strategy involves a non-discretionary fund manager who functions primarily as your financial advisor. The manager will provide you with the benefits and drawbacks of investing in a specific market or units of a company, but will not carry out any investment without your approval. The fundamental advantage of non-discretionary investment is that it allows you to consult with a financial professional without giving up control over your investment decisions.
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Now that you have understood the ways to manage your portfolio, let us dig into the ways to successfully evaluate it.
There are various ways to evaluate your portfolio. The traditional technique of performance measurement correlates investment returns to the yields of a given standard, disregarding the portfolio manager’s risks. The reference could be a market index, such as the Nifty 50 or the Sensex, or another portfolio of comparable size.
The risk-adjusted technique compares the portfolio’s returns to the benchmark’s returns. However, this strategy takes into consideration the varying levels of risk.
Apart from this, you can employ a certain formula for the quantitative analysis of your portfolio. The following three methods are most frequently used for portfolio evaluation:
I. Treynor’s measure
This measure is also known as the reward-to-volatility ratio. It takes into account the risk factor, or the volatility rate, as given by the beta coefficient. Moreover, risk is divided into the ups and downs in the price of the securities and changes that happen in the stock market.
The best part about using this measure is that you can apply it irrespective of your level of risk. The portfolio is evaluated using the following formula:
Treynor’s measure = (Portfolio return – Risk-free rate of return) / Beta coefficient
Let us take an example.
Suppose the annual return earned on the portfolio is 10%, while the risk free rate in the market is currently 6%. The value of the beta coefficient is given as 0.80.
Treynor’s value of the portfolio will be calculated as:
Treynor’s measure = (0.10 – 0.06) / 0.80
The value obtained is in terms of the return earned per unit of risk involved. Consequently, a high value implies a greater return– something you want to look out for.
Ii Sharpe’s measure
This ratio is given by Bill Sharpe and measures return on the basis of total risk, unlike the previous measure that only accounts for systematic risk, which is undiversifiable. Here, risk is calculated in terms of the standard deviation of the portfolio. The following formula is used to evaluate the portfolio’s performance:
Sharpe’s measure = (Portfolio return – Risk-free rate of return) / Standard deviation
Let us take an example.
The portfolio earns a return of 12% annually. The risk free rate in the market is 6%. The portfolio’s standard deviation is calculated at 0.20. In such a scenario, Sharpe’s measure will be calculated as:
Sharpe’s measure = (0.12 – 0.06) / 0.20
Since this ratio uses total risk, it also notes the effects of portfolio diversification.
Iii. Jensen’s measure
Michael C. Jensen gave this measure on the basis of the Capital Asset Pricing Model. Using this, you can calculate how much return you are earning over and above the expected return from the market. It is calculated as:
Jensen’s measure = Portfolio return – [Risk-free rate of return + (Beta coefficient) * (Market rate of return – risk free rate)]
The evaluation provides a value given as ‘alpha’. The higher the measure of alpha, the better. A positive value of alpha indicates that your portfolio has a consistent above-average performance. Conversely, a negative alpha is a sign of caution as it indicates a consistent shortfall of returns.
For example, the market rate of return is 10% and the risk-free rate is 6% at present. Portfolio A earns an annual return of 12% and its beta coefficient is 0.90. Portfolio B’s return is 10% and a beta coefficient of 0.70. Jensen’s measure in each case will be calculated as:
Alpha = 0.12 – [0.06 + (0.90)*(0.10-0.06)]
= 0.12 – [0.06 + 0.036] = 0.024 or 2.4%
Alpha = 0.10 – [0.06 + (0.70)*(0.10-0.06)]
= 0.10 – [0.06 + 0.028] = 0.012 or 1.2%
Employ any of these techniques to get a better view of your portfolio’s performance. We have further listed a few tips to aid you during this process.
Tips to keep in mind while evaluating your portfolio
Firstly, it is of utmost importance to evaluate how you have allocated traditional assets in your portfolio. Bonds are frequently employed in portfolios as a source of income as well as stability. Many investors overlook the opportunity of reinvesting the interest earned on bonds, when in fact it accounts for the majority of the return on fixed-income assets over time.
Secondly, always compare the performance of your mutual funds and exchange-traded funds (ETFs). These are high risk investments that provide high returns. Keep a check on the volatile rates and invest where you can profit the most.
Thirdly, keep in mind that expensive investment products can deplete a portfolio over time. Invest in a decent investment monitoring programme that will not only compute your portfolio expenses but will also show you how those expenses will affect your lifetime returns.
Always keep in mind your financial goals and evaluate your portfolio from time to time. If you are too occupied to do all the calculations, you can do the evaluation by entering your holdings into an automated investment analysis tool. All you have to do is manually enter the data or transfer data from a database. Your portfolio evaluation will be done at just a click, with all insights for you to analyse.
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