Portfolio Management

Portfolio management is the key skill that one requires for managing investment
effectively. Then whether he is an individual or HNI or a big MNC. Where HNI
stands for High Net Worth Individual and MNC stands for Multinational Company.
Different attributes of investment alternatives are analyzed and the objective of
investment guides where and how much money to allocate to each of the alternatives.
Investing in more and more assets, with different attributes, diversifies the risk of a
portfolio and thereby increases the reasonable assurance of the returns.

For understanding portfolio management (PM), it is important to understand the term

‘portfolio’, the meaning of PM, who is a portfolio manager, what does PM service
involve, classification of PM services, objectives, and importance of PM.

Table of Contents
1. What is Portfolio and Portfolio Management (Definition)?
2. Objectives of Portfolio Management
3. Principles of portfolio management ?
4. Advantages of portfolio management?
5. Disadvantages of portfolio management?
6. Who is a Portfolio Manager?
7. Process in Portfolio Management
8. Why is Portfolio Management Important?
9. Types of Portfolio Management
10. Active & Passive Portfolio Management
11. Discretionary & Non-Discretionary Portfolio Management

What is Portfolio and Portfolio Management

(Definition)?
The portfolio is a collection of investment instruments like shares, mutual
funds, bonds, FDs and other cash equivalents, etc. Portfolio management is the art of
selecting the right investment tools in the right proportion to generate optimum returns
with a balance of risk from the investment made.

In other words, a portfolio is a group of assets. The portfolio gives an opportunity to

diversify risk. Diversification of risk does not mean that there will be an elimination
of risk. With every asset, there is an attachment of two types of risk;
diversifiable/unique/unexplained/unsystematic risk and undiversifiable/ market risk /
explained /systematic risk. Even an optimum portfolio cannot eliminate market risk,
but can only reduce or eliminate the diversifiable risk. As soon as risk reduces, the
variability of return reduces.
Best portfolio management practice runs on the principle of minimum risk and
maximum return within a given time frame. A portfolio is built based on an investor’s
income, investment budget, and risk appetite keeping the expected rate of return in
mind.

Objectives of Portfolio Management

When the portfolio manager builds a portfolio, he should keep the following
objectives in mind based on an individual’s expectations. The choice of one or more
of these depends on the investor’s personal preference.

1. Capital Growth
2. Security of Principal Amount Invested
3. Liquidity
4. Marketability of Securities Invested in
5. Diversification of Risk
6. Consistent Returns
7. Tax Planning
Investors hire portfolio managers and avail professional services for the management
of portfolios by paying a pre-decided fee for these services. Let us understand who is a
portfolio manager and the tasks involved in the management of a portfolio.

PRINCIPLES OF PORTFOLIO MANAGEMENT

1. Larger expected portfolio return come only with large portfolio risk.
2. The risk association with a security type depends on when the investment will
be liquidated.
3. Diversification works.
4. Each portfolio should be tailored to the particular needs of its owner.
5. Its portfolio that matter.
6. Competition for abnormal returns is extensive.
7. Work with a trusted financial advisor .
8. Invest according to specific long term financial goals.
9. Balance time and risk.
10. Don’t let emotional dictate your investment decisions.

Table of Contents

1. Benefits of Portfolio Management

1. Helps in Avoiding Disasters

 2. Helps in Reducing Risks

3. Optimal Allocation of Funds

2. Drawbacks of Portfolio Management

1. No Downside Protection

2. Risk of Over-diversification

ADVANTAGES OF PORTFOLIO MANAGEMENT

Helps in Avoiding Disasters

 Portfolio management helps an investor in avoiding disastrous

outcomes that arise from otherwise investing in a single security.
 To avoid such disasters, investors should never invest in only one
security but should diversify their portfolios.

Helps in Reducing Risks

Avoiding disasters is important, but disasters are not as common as volatility in

the securities market. Following the previous example, suppose the investor has
USD 1000 and he would invest in it as follows:

If we look closely, even though the share of General Electric is in the loss,
overall the investor has made a good profit over the 5-year period. This is
because the investor has diversified his portfolio. Had he invested only in
General Electric, he would be making losses. Thus we can conclude that
portfolio management helps reduce downside risk through diversification.
Diversification acts as a shock absorber for a volatile market

Optimal Allocation of Funds

Any investor has limited funds to invest and would like to maximize the returns on his
investment. Portfolio management aides in maximizing these returns. A haphazard
investment methodology – buying a few stocks here, some bonds there, some gold
somewhere, is actually not a good investor behaviour. Portfolio management theory
gives investors a proper framework & many different calculation models to exactly
decide how much returns they want, and how to get it. This structured approach makes
it easy to allocate the limited funds availability & put it to optimum use.

There are a few drawbacks of portfolio management as follows:

Drawbacks of Portfolio Management

No Downside Protection
We must understand that even though portfolio management does help in reducing
downside risk, it doesn’t provide complete downside protection. When we select
investments to create a portfolio, we choose in a manner that there is structured
classification. We will invest in different asset classes, even within asset classes we
will select different sectors as per our goals. For example, sometimes a subset of
assets will go up in value at the same time that another will go down in value. An
investor will select from both the subsets to reduce risk. But there will be times, such
as the great meltdown of 2009, when the market crashes and the entire portfolio will
result in negative returns. There is no method in portfolio management to avoid such a
scenario. Thus we can say that portfolio management is a good tool when used in
normal or growing market, but during downfall or crash it becomes a little obsolete

Risk of Over-diversification
Over-diversification occurs when the number of investments in a portfolio exceeds the
point where the marginal loss of expected return is greater than the marginal benefit of
reduced risk. In other words, when adding individual investments to a portfolio, each
additional investment lowers risk but also lowers the expected return. Any portfolio
must only be diversified until a point where unsystematic risk becomes minimum.
This is usually a matter of judgment of the investors, and many times investors fall in
the risk of over-diversification. This leads to lower returns for the invested money.
This pitfall in portfolio management actually erodes investor returns.

There are always going to be some drawbacks to every theory & model. It is important
to assess that even with the drawbacks, how much a tool does helps us. Top of
FormPortfolio management has been used since 1930’s and has given such good
results over years & has become so common that even a layman understands when we
talk about “portfolio”. Portfolio management is the base on which an investment
strategy is built 1& the method is widely accepted by expert investment analysts,
portfolio managers, fund managers & the likes.

Who is a Portfolio Manager?

Portfolio Manager is a person who understands his client’s investment needs and
suggests a suitable investment mix to meet his client’s investment objectives. This
tailor-made investment plan is recommended keeping in mind the risk-return balance. 

Process in Portfolio Management

Portfolio management process is not a one-time activity. The portfolio manager
manages the portfolio on a regular basis and keeps his client updated with the
changes. It involves the following tasks:

 Understanding the client’s investment objectives and availability of

funds
 Matching investment to these objectives
 Recommending an investment policy
 Balancing risk and studying the portfolio performance from time to time
 Taking a decision on the investment strategy based on discussion with
the client
 Changing asset allocation from time to time-based on portfolio
performance
Why is Portfolio Management Important?
It is important due to the following reasons:

1. PM is a perfect way to select the “Best Investment Strategy” based on

age, income, risk taking the capacity of the individual and investment
budget.
2. It helps to keep a gauge on the risk taken as the process of PM
keeps “Risk Minimization” as the focus.
3. “Customization” is possible because an individual’s needs and choices
are kept in mind i.e. when the person needs the return, how much return
expectation a person has and how much investment period an individual
selects.
4. Taking into account changes in tax laws, investments can be made.
5. When investment is made in fixed income security like preference
share or debenture or any other such security, then in that case investor
is exposed to interest rate risk and price risk of security. PM can take
help of duration or convexity to immunize the portfolio.
Types of Portfolio Management
Portfolio Management Services are classified into two broad categories:

On the basis of a level of activity viz.

Active & Passive Portfolio Management
Active PM refers to the service when there is the active involvement of portfolio
managers in buy-sell transactions for securities. It ensures meeting the investment
objectives of the investor. Whereas Passive PM refers to managing a fixed portfolio
where the portfolio performance matches the market index. (i.e. market)

On the basis of discretionary powers allowed to Portfolio Manager i.e.

Discretionary & Non-Discretionary Portfolio

Management
Discretionary PM refers to the process where portfolio management has the authority
to make financial decisions. It makes those decisions for the invested funds on the
basis of the investor’s investment needs. Apart from that, he also does the entire
documentary work and filing too. Non-Discretionary PM refers to the process where a
portfolio manager acts just as an advisor for which investments are good and
unprofitable. And the investor takes the decisions.