Portfolio management is a coherent, focused strategy for managing investments in a harmonized fashion versus just buying and selling a collection of individual investment holdings.
What Is Portfolio Management?
Portfolio management entails managing a group of investments under an overall umbrella called a portfolio. A portfolio can be comprised of one or two different investment vehicles or a collection of various investments. These investments may be held in one account or in several, for example, a retirement account and a taxable investment account.
Portfolio management is a process of choosing the appropriate mix of investments to be held in the portfolio and the percentage allocation of those investments. Asset classes could include a mix of stocks, bonds and cash. These might be held in some combination of individual stocks and bonds, or via mutual funds or ETFs. Additionally, the portfolio might include alternative investments such as real estate, private equity or precious metals.
What Are the Objectives of Portfolio Management?
The goal of portfolio management is to manage this collection of investments in a fashion that is consistent with the investor's goals, their time horizon for needing the money and their tolerance for downside risk in their investments.
Portfolio management should dovetail with the investor's overall financial objectives. These could include saving for retirement, for the education of the investor's children or saving for a goal like buying a home. Often an investor will have multiple financial objectives that may be tied to their investments.
What Are the Key Elements of Portfolio Management?
Some key elements of portfolio management include:
Diversification refers to having a mix of investments that are not all highly correlated to one another. The reason for having investments with a low correlation to other holdings in the portfolio is to try to ensure that the entire portfolio doesn't suffer a large loss whenever the stock market, or a certain sector, moves downward.
For example, stocks and bonds have a low and some cases a negative correlation to one another. This means that the market and economic factors that cause price movements in stocks will have little or no impact on the price movement in bonds. Alternative assets such as real estate, gold, hedge funds, private equity, currencies, futures, commodities and others can be used to diversify a portfolio away from more traditional asset classes like stocks and bonds and well.
Asset allocation refers to how an investor divides up the eggs in their investment basket, so to speak. Proper asset allocation is a key element in portfolio management. Asset allocation is about risk management. The mix of assets in a portfolio can help reduce risk in line with the risk tolerance of the investor.
Over the years, several studies have pegged asset allocation as the key determinant of both the return of a portfolio and the volatility of that portfolio.
Asset allocation is a good start, but a key part of portfolio management is rebalancing the portfolio periodically back to the target asset allocation. Over time the actual performance of investment holdings in the various asset classes within the portfolio will perform at different levels relative to each other. Perhaps small cap stocks will lead the pack for a couple of quarters, but then international stocks will experience a period of relative outperformance.
Over time differing returns will cause the asset allocation to deviate from the investor's target allocation. (For example, if you originally placed 10% of your portfolio in small cap stocks, over time the holding might have grown to become 15% of your portfolio.) This can cause the portfolio to assume more or less risk than desired.
Periodically the portfolio should be rebalanced back to the target allocation. This can be done by buying and selling holdings as needed. It can also be done by using new money added to the portfolio if applicable.
If an investor's portfolio includes investments in both tax-deferred (or tax-free in the case of a Roth account) retirement accounts and in taxable accounts, asset location should be a consideration. Asset location refers to which types of assets are held in which accounts. This is a tax-driven issue.
Long-term capital gains taxes as well as those on qualified dividend payments are often less for many investors than taxes on ordinary income from sources including interest. Investments held for more than a year qualify for preferential long-term capital gains rates on any gains from the sales of these investments. These factors may favor holding more equity related investments in taxable accounts with a heavier concentration of interest generating investments, such as bonds and other fixed income vehicles, in tax-deferred accounts.
The concept of asset location should be integrated with an investor's asset allocation as part of the portfolio management process.
Why Is Portfolio Management Important?
Investing is not a set-it-and-forget-it proposition. Portfolio management doesn't mean watching and monitoring the portfolio constantly, but it does mean monitoring things on a regular, consistent basis.
Investor circumstances can change. Their goals and objectives can change with the passage of time and life changes. These changes might call for a portfolio adjustment.
Individual holdings might need to be replaced from time to time. An actively managed mutual fund might undergo a change in the fund's management. This might lead the portfolio manager to make a change to another fund holding.
A portfolio approach to investing is important as well. Some investors simply accumulate a number of individual holdings with little thought as to how all of their various investments work together. This can lead to being over-allocated in a single area which can expose the investor to more risk than they might realize they are assuming.
Investors are wise to take a portfolio management approach to their investments, whether they do this themselves or hire professional help.
A portfolio-focused investment approach blends the right mix of investments to help investors fund their financial goals, while taking their time horizon to meet those goals and their risk tolerance into account. A well-managed portfolio will provide investors with the diversification needed to help achieve their investment goals and is a part of an overall financial plan.
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