What are the phases of portfolio management?

 What are the phases of portfolio management? 

How to determine overpricing/underpricing?

What is fundamental analysis?

What is technical analysis? 

How to construct a diversified portfolio?

Phases of Portfolio Management

1. Meaning:

Investment in shares, debentures, bonds, etc. is lucrative and exciting for investors. While such investments yield good returns, they also involve some risks. 

Therefore, you are required to have a good amount of scientific and analytical skills to make the investment in those securities. 

There’s a famous proverb that you should not put all eggs in the same basket. Likewise, you should not invest your entire fund in a single security. In both cases, the likelihood of loss is substantial.

However, when you invest in a well-diversified portfolio; you can optimize your risk-return profile. 

Optimizing your risk-return profile means making investments in such a portfolio that can reduce your risk without diluting the returns.

The portfolio is a collection of investments like shares, debentures, bonds, etc. 

Portfolio management is the art of selecting the right investment tools in the right proportion to optimize the risk-return profile.

2. Characteristics of Investment:

Every investment is characterized by risk and return. 

The risk means the probability that the actual rate of return from a security or a portfolio of securities differs from the expected or average rate of return. It is measured by standard deviation or variance of the rate of return. 

Return means the amount of money received from investment over a certain period of time.

3. Phases of portfolio management:

Portfolio management is the process of optimizing the risk-return profile of a portfolio. This process can be done in five phases. 

Each phase is an integral part of the process. The success of your portfolio management depends upon how effectively and efficiently you carry out each phase:

A.    Security Analysis:

You may have numerous types and numbers of securities. 

On the basis of ownership, your securities can be classified into shares, debentures, preference shares, and bonds. 

You may also have securities with innovative features such as Convertible Debentures, Deep Discount Bonds, Zero Coupon Bonds, Flexi Bonds, Floating Rate Bonds, Global Depository Receipts, and Euro-currency Bonds, etc. 

Now your task is to select the ones to be included in your investment portfolio from those innumerable securities. 

For this, you have to perform a detailed analysis of all securities.

You can perform a detailed analysis by examining the risk-return profile of individual securities and also the correlation among them. 

A simple trading strategy is used i.e. buy cheap or under-priced securities and sell costly or overpriced securities. 

Now you might question how to identify under-priced or over-priced securities and this is what security analysis is all about.

How to identify under-priced or over-priced securities?

For this, you can use two approaches viz. fundamental analysis and technical analysis. 

These analyses are based on different premises and involve different techniques.

I. Fundamental analysis: It is one of the oldest techniques and considers the following factors that affect the company:

-The EPS of the company and dividend pay-out ratio

-The market share and quality of management

-The fundamental factors affecting the industry in which the company operates

-The competition faced by the company

Under the fundamental analysis, you can compare the intrinsic value (true worth of a security based on its fundamentals) with the current market price. 

If the market price is higher than the intrinsic value the security is overpriced and in the case of the reverse opposite is true i.e. security is underpriced. 

I would always prefer to buy underpriced securities or sell overpriced securities if I own some.

II. Technical Analysis: This approach assumes that share price movements are systematic and exhibits consistent patterns. 

You can study the past movements in the prices of the shares and identify the trends and patterns in security prices. 

These trends and patterns can be used to predict future price movements of the security.

How to construct a well-diversified portfolio?

You can construct a well-diversified portfolio by eliminating or substantially reducing the Unsystematic Risk. 

Unsystematic Risk can be reduced by selecting securities across diverse industry sectors which do not have a strong positive correlation among themselves.

Criticisms of two approaches

I. Random Walk Theory: This theory holds that share movements are random and not systematic. Consecutively neither Fundamental Analysis nor Technical Analysis is of value in generating trading gains on a sustained basis.

II. Efficient Market Hypothesis: It does not subscribe to the belief that it is possible to book gains in the long term on a sustained basis from trading in the stock market.

Conclusion: The markets, though becoming increasingly efficient everywhere with the passage of time, are never perfectly efficient. 

So, you have opportunities all time although their durations are decreasing and if you are smart enough you can look forward to booking gains consistently out of the stock market deals.

 

B.     Portfolio Analysis:

Once you have identified the securities for investment, your next step is to combine them to form suitable portfolios. 

Each portfolio formed has its own risk-return profile. The risk and return of each portfolio can be computed mathematically based on the risk-return profile and correlations among them.

You can construct numerous portfolios by selecting different types of securities and varying the amount of investment in each security. All such portfolios are termed feasible portfolios.

C.    Portfolio Selection:

Your goal is to identify an efficient portfolio from among the whole set of portfolios identified as feasible. The efficient portfolio is one

-which has the highest return at the same or lower risk

-which has the lowest risk at the same or higher return

Now you can form a set of efficient portfolios and from these efficient portfolios, you can select the optimal portfolio for investment.

You can determine optimal portfolio by using analytical tools or by using the conceptual framework provided by Markowitz’s portfolio theory.

 D.   Portfolio Revision:

After an optimal portfolio is formed you need to constantly monitor the portfolio to ensure that it continues to be optimal. 

Since the economy and financial markets are dynamic in nature, securities which were once attractive cease to be so with the passage of time. 

And new securities with high returns and low risk may emerge. Considering such changes, you need to revise your portfolio. 

You can do this by buying new securities and selling existing securities from the existing portfolio. As a result the nature of securities and their proportion change.

Your portfolio may also be changed when you have additional funds available, your risk appetite changes, or when you need cash for other alternative use.

E.     Portfolio Evaluation:

In this phase, you should perform the regular analysis and assessment of portfolio performances in terms of risk and returns over a period of time. 

During this phase, the returns are measured quantitatively along with risk born over a period of time by a portfolio. 

The performance of your portfolio is compared with the objective norms. 

Moreover, this procedure assists you in identifying the weaknesses in the investment processes and improving the deficient areas.

Conclusion:

It should however be noted that portfolio management is an ongoing process. It starts with security analysis, proceeds to portfolio construction, continues with portfolio revision, and ends with portfolio evaluation. Superior performance is achieved through continual refinement of portfolio management skills.

 

 

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