Portfolio Management

Information on this webpage is provided as factual information only. We do not give general or personal advice in respect to Portfolio Management. You should not consider this webpage as a recommendation or any type of advice. You should seek competent financial planning advice from an accredited and licensed financial planner, before making a decision regarding Portfolio Management.

Portfolio management is the process of making decisions regarding investment mix, methodology and objectives for investment, balancing risk against return to suit the investor’s tolerance. When making these decisions, the investor or manager (if the investor has appointed one) needs to balance the risks of the desired investments against their expected return by investing in different asset classes (shares, bonds, cash, property and other) to achieve a long-term investment strategy that is optimal.

Asset Classes available in the stock market

In this article we will be looking solely at portfolio management within the stock market, to show the spectrum of direct and indirect assets an investor can gain exposure to.

The major asset classes are:

  • Domestic Shares – When you own a share, you own a piece of the company, or a piece of equity in the firm. Over time, the increase or decrease of the company’s value is reflected in the increase or decrease of your share’s value.
  • Property – Simply put a piece of land, a house, office building, warehouse etc. When investing in property via the stock market typically you invest in a company who owns a portfolio of properties and manages them as a REIT (Real Estate Investment Trust). The cumulative change in the value of the properties is reflected in the company’s value and thus the shares.
  • Cash/Bonds – The alternative to putting your money in a bank account or term deposit. These investments allow the investor to lend money to a listed corporation on the ASX in return for a regular income stream in the form of an interest payment (or coupon) and at maturity of the debt as re-payment of the initial investment amount. This debt instrument’s value is influenced by the prevailing interest rates and the ability of the underlying company to repay the debt.
  • International Shares – Many listed investment vehicles on the ASX allow investors to make an investment in companies that aren’t Australian. These can be CDI’s (Chess depositary Interests) or ETF’s (Exchange Traded Funds) as well as some platforms that allow investors to buy shares in other markets. These function in the same way as Australian shares but have the additional impact of movements in exchange rates to consider.

Each of these asset classes has different risk/reward profiles, cash/bonds being the safest and international shares being the least safe. Also within each asset class the assets have differing levels of risk relating to the businesses they are invested in, the underlying investment and the method by which the investment is managed and created. For example, there are many banking stocks on the stock market, each one is different, owned and managed by different people with different levels of profitability and risk. Efficient and effective portfolio management is about maximising returns for the investor’s desired level of risk.

Portfolio Management Theory

In the below diagram different portfolios are represented as dots along the axes of risk and return. The efficient frontier is a concept whereby the maximum possible return on a portfolio is achieved for a given amount of risk. Any portfolio sitting on this frontier is efficient, anything underneath is not being managed efficiently.

To develop an efficient portfolio you need to start with a clear idea of how much risk is acceptable as an investor. When this is known you can compare the sectors and asset classes which match the risk profile you are hoping for to find the asset class and sector with the most potential. Often this involves the use of top-down analysis to find the sectors with the greatest potential given the economic cycle and prevailing market conditions. From here you can look at the micro economics to pinpoint which companies are well run and managed, thus giving you the best chance of achieving an optimal return.

To develop an efficient portfolio you need to start with a clear idea of how much risk is acceptable as an investor. When this is known you can compare the sectors and asset classes which match the risk profile you are hoping for to find the asset class and sector with the most potential. Often this involves the use of top-down analysis to find the sectors with the greatest potential given the economic cycle and prevailing market conditions. From here you can look at the micro economics to pinpoint which companies are well run and managed, thus giving you the best chance of achieving an optimal return.

Diversification

Unforeseen circumstances occur all the time, leaving your portfolio at the mercy of global economic news and specific events that affect either the fundamental economic outlook or particular industries. Geographical disasters, political tension, economic events and individual company management decisions can leave a seemingly solid investment falling dramatically. By investing in a variety of stocks, sectors and asset classes the individual events and shocks that affect different investments can be mitigated or avoided. The role of diversification is to avoid investing in a great stock and find that something unforeseeable has changed the outlook of its profitability.

Another key benefit of diversification is that the risk/return profile of a portfolio can be aggregated to achieve something that is unachievable using only one or two single asset classes. A bond-only portfolio could not achieve the high-returns of a share portfolio which has too much risk for an investor. Using a combination of shares and bonds the investor can take the high-returns of a concentrated share portfolio while still keeping a safe backbone of bonds that should hold their value in the most trying of economic conditions.

Standard Investment Portfolios

Some terms are well understood within the context of investing and portfolio management. Below we shall discuss some:

  • Income Investor – An income focused investor requires that their portfolio provides the best income possible. For this reason they will typically have a high proportion of high dividend paying shares, bonds, hybrid or interest rate securities. For this investor a regular payment stream is the highest priority.
  • Growth Investor – A growth focused investor requires that their portfolio provides the highest growth possible in the value of the shares (compared to value paid in regular cash streams). These investors will have shares that pay a lower dividend yield or have their dividends reinvested into extra shares on a regular basis. For this investor growth in value of the portfolio is the highest priority.
  • Large Cap, Mid Cap, Small Cap (shares) – These terms relate to the overall size of the company being invested into. Typically Large Cap companies are worth more than $10 billion, Mid Caps are typically between $2 billion to $10 billion and Small Caps have a value less than $2 billion. There are also Micro Caps who typically are worth less than $500 million. Small and Micro Cap stocks are higher risk due to lower liquidity.
  • Aggressive, Moderate, Defensive (Portfolio Allocations) – While these are not set in stone, typically an aggressive portfolio will be 65 – 70% invested in equities, 20-25% allocated to fixed income securities (bonds, hybrids, interest rate securities) and 5-10% cash. A moderate portfolio will be roughly 50-55% equities, 35-40% fixed income securities and 5-10% cash. A conservative portfolio will be roughly 15-20% equities, 70-75% fixed income securities and 5-15% cash.

Each of these asset classes will need to be managed individually. In a portfolio with equities the investor wants to look at the companies chosen to have a mix of safer and riskier shares. In some circumstances the mix of stocks (Large Caps, Mid Caps, Small Caps) can replace the weightings in fixed income securities, equities or cash (ie. 60% large caps, 20% mid caps, 10% small caps and 10% cash).

Maintaining the portfolio

Over time the best performing classes will become larger proportions of your portfolio. To maintain the risk profile you need to rebalance the portfolio back to its original weightings. On top of this the investments in a portfolio will have to be switched over time to move from companies that are not continuing to grow, or have reached a level where they are no longer the most efficient investment choice. It is best to switch these portfolios around on a regular basis and doing constant research on the market helps to keep your portfolio efficient.

Finally, portfolio management is a proven strategy to grow wealth over time. Using correct research and discipline in maintaining the risk/return profile, investors can grow a valuable investment portfolio to achieve their financial goals in the long-run.