Portfolios & Strategies

Introduction

A portfolio typically means collection of particular things kept together for future use. When it comes to finance, a portfolio involves all investment assets held by an investor. Here again it does not mean that an investor should or will have only one portfolio. Multiple portfolios can be built according to his/her goals and risks tolerance. We learnt about importance of investment and different asset classes available for investment in the first two modules. And we also had a glimpse on the importance of having risk management tools in place. Now let us see how to build and manage a financial portfolio with all the things we have learnt so far in the previous modules.

Building a financial portfolio

As we move on, we will recollect what we learnt and understand how to implement it while building a portfolio.

When we think of investment, we should think of the elements and principles that are involved in investment. They are risk, reward, time and safety, profit, liquidity and taxation.

Now we will see step by step approach to building a portfolio keeping the above points in mind.

Step 1: Set your objectives and goals/ Calculate your risk profile/ Decide on the time horizon

a. Objectives and goals

First step is to define your financial goals. And, financial goals differ for each individual according to their age and financial responsibilities. However, as years pass on, the financial goals changes as responsibilities and needs changes. A young person at the age of 25 who do not have any financial responsibilities will have different goals and a person who is married and have more responsibilities will have different goals. For example, a married man will have to invest for his child’s education and marriage. Whereas, a fresh graduate will be free from such responsibilities and his goals and objectives will be different.

b. Time horizon

Based on the goals, one has to decide the time horizon of his investment. For example, a man who is married recently and is of 25 years of age has a greater number of years to save for his child’s higher education or marriage. And there could also be a financial need in next 2 or 3 years for which he has to invest. So, the time horizon changes for different financial needs. Accordingly, you should decide on different time horizon for the investment you make for different needs.

Different portfolios can be built to meet different goals. Differentiate between your long-term goals and short-term goals. Short term goals can be achieved by investing in fixed income securities such as short-term bonds or liquid funds. For long-term goals, investing in equities will yield remarkable returns to beat the inflation.

c. Risk

Everyone invests for profit. But why do we need profit? Answer is “To beat the inflation”. We want our money to grow faster than the inflation rate. But at what cost? How much risk can you take to earn profit? Is there a safety to your principle amount? You need to ask these questions to yourself to assess your risk profile.

To calculate your risk tolerance, you should think of your job and flow of income, your age, health and the emotional stress you could tolerate. To invest regularly, you need a stable income. So, you have to plan your income first to allocate money for investment.

Step 2: Asset Allocation

Depending upon your goals and risk profile, you can decide on the asset class in which you need to invest. Selecting the right asset class and the right allocation of investment in different asset class is the most important and first step of building a profitable financial portfolio. And this is called “Asset Allocation”. Different asset class offers different returns with different risk and time horizon. So, based on your goals you can choose the assets you want to invest in to achieve your financial goals. For example, you can invest in equities to achieve your long-term goals and invest in short term bonds to meet your financial needs that arises within next 2 to 3 years.

Asset allocation should also be based on your age and risk profile. As equities are riskier than bonds, a risk averse person in the age group above 40 can allocate more funds to bonds and less to equities. The asset allocation for persons at different age is presented below as an example.

 

 

In this example, you can see the man at age 25 allocating 85% of the funds to equities. A young person has a greater number of years in his life and so he can invest in equities because equities gives a superior return in the long run. Whereas, for a person who is at 55 years it will be prudent to reduce the exposure to equities and include more of fixed income securities and maintain cash asset for emergencies. Cash is also a financial asset and it is the only asset that is not co-related with any other asset class (Read about this in the chapter “cash and cash equivalent” in the module “Asset Class”).

If you are willing to take more risk you can build an aggressive portfolio where equity investment forms the major part of your portfolio. If your risk tolerance is less then you can allocate more funds to bonds and gold than equities.
Another important aspect in asset allocation is to check the liquidity of the asset. You should be able to liquidate the investment at right time without difficulty. So, it is necessary to have liquid assets as buffer to take care of the systematic risk (Read more about investment risk in the chapter “Risk Management” under the module “Investment Basics”).

Step 3: Diversification and position sizing

You would have heard a popular saying “Do not put all the eggs in one basket”. What does it mean? You may have equities, bonds and gold in your portfolio but still can it be called a well-diversified portfolio? Just investing in different asset class is not enough. It is important that how well you have spread your investment between various sub classes under a major asset class. For example, equities include equity shares of companies operating in different sectors and each one has different market capitalization. When you build your portfolio, you should spread your investment among different sectors and stocks. This is called diversification. Diversification is one tool to manage the risk in investment. Diversification helps your portfolio from unsystematic risks which affects a particular company or a sector (Read more about investment risk in the chapter “Risk Management” under the module “Investment Basics”).

Position sizing involves allocating the right amount of funds to invest in a particular stock or a particular sector or stocks of particular capitalization groups. Risk averse person can allocate more funds to large cap stocks and aggressive investor can allocate more funds to mid-cap stocks. It is always prudent to avoid having too much exposure to one sector or capitalization or in a particular stock. Right mix of stocks plays a vital role in managing the risk and achieving your goals.

Managing the financial portfolio

To achieve your investment goals however, just building a portfolio does not work. Rather it has to be managed well. After building a well allocated and diversified portfolio, it needs to be regularly overhauled as we do to our vehicle or service the air-conditioners.

Why it is necessary? Because as we saw in previous modules over a period of time investment opportunities keeps evolving and your goals and objectives and also risk bearing capacity may change. Further the market value of your investment changes and or the prospects of the asset you have invested in may also change. Accordingly, you need to alter your allocation and re-balance your portfolio to achieve your financial goals. This exercise should be done regularly at periodical intervals and whenever the need arises.

Monitoring and re-balancing of portfolio

What does monitor of portfolio means? As days move on the market value of your investment keeps changing. For example, in an equity portfolio, market value of your investment in one stock or sector would have increased and other stock or sector would have reduced. What impact does this make on your whole portfolio? Let us assume that originally, when you built a portfolio, you allocated 10% of your total portfolio value to stock “A” and 15% to stock “B”. Now after few months, if the value of stock “A” had increased by 80% and stock “B” had decreased by 50% the percentage of exposure to those stocks in your portfolio also increases or decreases accordingly. This also means the weightage of those stocks have changed and you would like to bring it back to the originally decided level.

How do you do it? You have to reduce the quantity of shares you have of that stock. Suppose you have 100 shares of stock “A” you can sell 25 shares or 50 shares out of 100 to bring it back to the original level in your portfolio. And use the sale proceeds to buy some more quantity of the shares whose value has reduced. This exercise is called re-balancing of portfolio. This exercise should be carried over to re-align the sector wise exposure and capitalization wise exposure of the portfolio.

So far we have seen the re-balancing of sub class of equity asset class, the same exercise should be followed to re-balance the exposure to overall asset class. For example, if 60% of your portfolio consists of equities and 30% of bonds and 10% of gold. Let us assume that over few months, gold prices skyrocketed and the value of gold investment in your portfolio increased to 20% and equity investment has reduced to 50%. If you want to retain your exposure to gold at 10% and if you think equities will outperform, you can offload some of the gold assets and invest the proceeds in equities so as to bring it to the original 60% of your total portfolio value. This re-aligning of portfolio helps in achieving your financial goals. To understand the importance of re-aligning the portfolio, let us assume that you failed to exit the gold investment when the value moved up significantly and consequently did not add on to the equity investment. Imagine what will happen to your portfolio value if gold prices fall and equities outperforms after few months. You will lose the equity gains as well as the profits in gold investment. So, continuous monitoring and re-balancing of portfolio is necessary to achieve targeted goals.

Ways of shuffling or re-balancing of portfolio

In the previous sub-heading, we discussed about the need to re-balance the portfolio and we saw that the exposure to the overweight asset (prices of which has increased) has to be reduced and exposure to the underweight asset (prices of which has reduced) has to be increased according to our goals and objectives. So, it involves selling and buying of the securities or asset. Here are few ways and ideas by which the shuffling of portfolio can be done.

Re-balancing of portfolio can be done on a broader base I e., if the market value of a particular asset as a whole increase for example gold value increase, then we can offload some of the gold assets and invest in equity or bonds. Similarly, if the equity value increase, we can offload some and invest in other asset class. But in this section, we will see about some of the principles to be followed while re-balancing of equity portfolio. This is important to know because, equity portfolio includes investment in sub-classes such as sectors, themes, or capitalization.

Re-balancing is essentially a selling exercise. One needs to have exit strategies to while building a portfolio. Following are sample of some exit strategies. However, you can define your own strategies according to your assessment and goals.

• Set stop loss and target for individual stocks you own. Once the target is achieved or stop loss is breached, you can re-balance the exposure to that stock.
• Similarly, if the percentage exposure to a particular sector in the total portfolio increases above your targeted level you can think of re-balancing of portfolio.
• Same can be applied for total exposure to the stocks belonging to a particular market capitalization
• Pre-determined target and stop loss levels can be fixed for the total portfolio value also.

The exceptions to the above however, is if you think the prospects of a stock that has reached your target is still good and the stock enjoys higher re-rating, then you can hold on to that stock and exit the stock whose future outlook is bleak. To know how to assess the fundamentals of a stock please refer the module on “Fundamental Analysis” in this website.

Other points to note on building and managing a portfolio

• Remember portfolio creation happens over a period of time. And it is not a one-time exercise. A financial portfolio can be built with regular and disciplined investment approach and it can be done with SIP route.
• If you are building an equity portfolio, it is always better not to have too many stocks in your portfolio. Having a smaller number of stocks will enable you to keep track of the individual stocks fundamentals and performance and you will not lose sight of important developments that needs your attention.
• You can build a financial portfolio using mutual funds and or exchange traded funds (ETFs). Learn more about ETFs here.
• The objective of building a portfolio is wealth creation that is possible only with long-term perspectives. However, if you want to take advantage of short term gains that market offers, you can allot a small portion (5 or 10%) of the portfolio for short term trading.
• While re-balancing the portfolio, never hesitate to weed off the laggards. Many do the mistake of exiting the profitable investment and holding on to the losers as they do not want to book loses. Be brave enough to book small loses to avoid bigger loss.

Key points to remember

• A financial portfolio is a group of financial assets such as equity, bonds, cash etc.,
• To build a portfolio first we should define our goals and objectives and assess our risk bearing capacity and decide upon the tenure of investment.
• Building and managing a financial portfolio is an ongoing process and it requires continuous re-balancing.
• Re-balancing is required as investment opportunities and our goals and objectives changes over a period of time.

Round Up

Building a financial portfolio is important to achieve financial freedom. We can achieve financial freedom as earlier as we start investing. A good portfolio can be built by Investing in different asset class and sub class which is also called asset allocation. With continuous monitoring and re-adjusting the assets, one can achieve their financial goals as perceived.

 

Suggested Readings

1. "Behavioral Portfolio Management” by C. Thomas Howard
2. "Modern Portfolio Theory” by Harry Markowitz