Portfolio Management: A Complete Guide
It’s fun to pick the stocks and bonds that go into your portfolio, but there is more to it than that. Good portfolio management begins before you pick your first stock. Later, it involves measuring the results of your portfolio management strategy and security picks.
A good portfolio management strategy begins by setting goals for the money in your account. Those goals can be anything from saving for a home, retirement, charity, a child’s education or a combination of things. Go ahead and get crazy! It’s your money, after all.
Once you’ve decided what you’re going to do with your investment portfolio, you’ll have a good idea of your time horizon. Your time horizon is like a deadline for your money. If you plan to retire in 20, 30 or 40 years, you can incorporate that time horizon into your portfolio management strategy.
Your time horizon can also help you decide how much volatility your account should take. For instance, some securities like stocks typically have higher ups and lower downs than bonds. You have a short time horizon if your time horizon is only a few months or years away.
Investors with short time horizons might find stocks too risky. It’s not that holding a group of stocks is a risk itself; the risk is that the stocks fall right at the finish line of your goal.
Portfolio Management Strategies
The key to a good portfolio management strategy is asset allocation. Asset allocation goes beyond the stocks, bonds, cash or other investments you choose to put in your portfolio. It is also the percentage of each asset class you chose.
If your time horizon is only a few months, you may choose to put 0% of your money in stocks. Since you have no stocks, you may want to keep your money mostly in cash because it won’t fall. Investors with very long-time horizons may want a much larger allocation to stocks. With a longer time horizon, investors can tolerate a fall in stocks and benefit from the higher potential return of stocks.
Another thing to consider is that the price of your stocks and bonds will fluctuate over time. When that happens, your initial asset allocation can change also. For instance, say you started your account with 75% and 25% bonds. After a year, stocks have done better than bonds, and your portfolio is now 85% stocks and 15% bonds.
To keep your asset allocation the way you want, you can sell stocks and buy bonds until your account is back to its intended 75% stock and 25% bond allocation. Investors call this portfolio management strategy rebalancing.
Types of Portfolio Management
When you’ve picked the right asset allocation for you, the next step is to pick the right investments. You can choose to pick your own stocks and bonds or take a hands-off approach.
An active portfolio management strategy allows investors to pick their own investments in stocks and bonds. Investors may choose active portfolio management because they believe they earn a higher return than stock market indexes, or they just like to do it.
A passive portfolio management strategy chooses stock and bond investments made to match stock and bond indexes. Index stock or bond mutual funds and ETFs can be an easy way for investors to meet their asset allocation strategy quickly and easily.
Keep in mind that a passive strategy will never outperform the market. On the other hand, it will never underperform either.
If you like a strategy that can give you the chance to outperform the market without taking the time and effort to pick your own stocks, you’re in luck! Professional portfolio managers manage active mutual funds or ETFs that try to outperform their index over time.
Diversification is the idea that you shouldn’t put all your eggs in one basket. For instance, it would not be a good idea for a stock investor to put all their money into one stock. The risk is that the stock does very poorly or, even worse, goes to zero! In that case, it could take years to recover and may put your financial goes in serious jeopardy.
Smart investors will diversify their stocks. That way, if a few of their stock picks do poorly, the whole portfolio can still reach its goals.
In addition to diversification within stocks, investors may want to diversify across asset classes. Different asset classes like stocks, bonds and cash are typical. Investors may also hold securities in asset classes like real estate or commodities.
You can even diversify within each asset class. For instance, you can hold large, mid, and small-cap stocks within your stock allocation. Within your bond allocation, you can have municipal, corporate, treasury and many other types of bonds.
Every good portfolio management strategy includes a look at the rate of return of the accounts. There are a few different ways to measure the rate of return. The simplest way to look at the rate of return is the holding period rate of return. This measure does not consider the time that the security or portfolio was held.
The formula looks like this:
(P2 – P1) / P1
P1 = Value at the beginning
P2 = Ending Value
Most of the time, rates of return are annualized. That means returns are calculated on a per-year basis. If the return period is less than a year, the returns are extended to a yearly basis. This way, securities, and portfolios can be compared to each other fairly.
Often, investors use the Internal Rate of Return (IRR) to find the annualized rate of return for their investment. The formula for IRR is very complex and not easily calculated by hand. Instead, you can more easily find the IRR of an asset or portfolio with a financial calculator or an Excel spreadsheet.
Investors should also think about how taxes on their investments. For example, municipal bonds are typically tax-free. So, comparing the return on a tax-free investment is different. For tax-free investments, investors can find their tax-equivalent yield.
About BJ Cook
BJ Cook is a long-time stock nerd. He has held several roles in the equity research world and earned the right to use the CFA designation in 2014. When he’s not writing for Investment U, you can find him searching for new investment ideas. Outside the investment community, BJ is a die-hard Cubs fan.