| Key Terms in Portfolio Management, With Examples | ||
|---|---|---|
| Term | Definition | Examples |
| Active Management | A strategy where portfolio managers actively buy and sell securities in an attempt to outperform a benchmark. | A fund manager might overweight technology stocks believing the sector will outperform the market. |
| Alpha | The excess return of an investment relative to its benchmark. | An alpha of 1% means the investment outperformed its benchmark by 1%. |
| Asset Allocation | The distribution of assets (e.g., stocks, bonds, real estate) within a portfolio to achieve a preferred risk-return profile. | Conservative investors often have a higher allocation of bonds, while aggressive investors want more exposure to growth stocks. |
| Asset Class | A group of investments with similar characteristics (e.g., stocks, bonds, real estate). | A diversified portfolio might include multiple asset classes. |
| Benchmark | A standard against which the performance of an investment or portfolio is measured. | A common benchmark for U.S. stocks is the S&P 500 index. |
| Beta | A measure of an investment's volatility in relation to the overall market. | A beta of 1 means the investment moves in line with the market, while a beta greater than 1 indicates higher volatility. |
| Diversification | Spreading investments across assets to lower risk. | Owning stocks from different industries or countries. |
| Index Fund | A type of mutual fund or exchange-traded fund (ETF) that tracks the performance of a specific market index | , which tracks the largest 500 American publicly traded companies in terms of market capitalization. |
| Liquidity | The ease with which an asset can be converted into cash without affecting its market price. | Stocks and ETFs are considered more liquid than real estate. |
| Net Asset Value (NAV) | The value per share of a mutual fund or ETF on a specific date or time. | The NAV of a mutual fund fluctuates daily based on the market value of its underlying holdings. |
| Passive Management | A strategy that aims to replicate the performance of a benchmark index, often through investing in index funds or ETFs. | An investor might choose a passive S&P 500 index fund to mirror the performance of the U.S. large-cap market. |
| Portfolio Optimization | The process of selecting the best portfolio (asset allocation) given the investor's constraints and objectives. | Modern portfolio theory is a common approach to portfolio optimization. |
| Rebalancing | Adjusting a portfolio's asset allocation back to its target percentages to maintain the desired risk-return profile. | Selling some stocks and buying more bonds to return to a target allocation of 60% stocks and 40% bonds. |
| Risk Tolerance | An investor's ability and willingness to withstand changes in the value of their holdings. | An investor with a high-risk tolerance might be comfortable with a portfolio of mostly stocks. |
| Risk-Return Tradeoff | The principle that potential returns rise with an increase in risk. Thus, lower-risk investments offer lower potential returns, while higher-risk investments offer higher potential returns. | Stocks are generally considered riskier than bonds, but they also have the potential for higher returns. |
| Sharpe Ratio | A measure of risk-adjusted return, calculated as the excess return of an investment over the risk-free rate divided by its standard deviation. | A higher Sharpe ratio indicates better risk-adjusted performance. |
| Tracking Error | The difference between the performance of a portfolio and the performance of its benchmark index. | A tracking error of 1% means the portfolio's return deviated from the benchmark's return by 1%. |
| Turnover | The percentage of a portfolio's holdings that are sold and replaced over a specific period. | A high turnover rate can result in higher transaction costs and have tax implications. |
| Volatility | The degree of variation in prices over time for a given asset. | Stocks with high volatility experience larger price swings than those with low volatility. |
Who Uses Portfolio Management
Portfolio management is a critical investment practice used by two types of entities: individual and institutional investors. These categories have distinct strategies, goals, and resources. Understanding the different approaches and needs of these two types of investors can provide greater insight into how portfolio management techniques are applied across the financial spectrum.
Individual investors often focus on personal wealth and future needs, managing smaller amounts of money with varying degrees of professional assistance. In contrast, institutional investors manage large-scale assets with a professional approach tailored to fulfill specific financial obligations and institutional goals. Both groups, however, aim to improve their returns by managing their portfolios to tailor them for specific circ*mstances and financial objectives.
Individual Investors
Individual investors have a range of personal goals, risk preferences, and resources. Their objectives include saving for retirement, accumulating wealth for large purchases, funding education for children, or building an emergency fund. Each goal requires a different strategy or risk profile.
The risk tolerance as well as investment knowledge among individual investors varies greatly. In addition, their approach to managing investments can range from highly engaged active trading and rebalancing to relying on automated or professional management. As financial markets have evolved and technology has widened access to investment information, individual investors have had wider prospects to tailor their investment strategies to meet their personal financial objectives.
Institutional Investors
Institutional investors are entities that pool large sums of money and invest those funds into various financial instruments and assets: pension funds, endowments, foundations, banks, and insurance companies. Each has specific objectives and constraints that influence their portfolio management strategies. Many institutional investors have long-term financial obligations that cause them to focus on long-term growth and sustainability over short-term gains.
In addition, institutional investors are often under strict regulatory oversight to ensure they manage their beneficiaries' funds responsibly. Moreover, ethical and social governance issues increasingly influence their investment decisions. Risk management is a crucial part of the work of an institutional portfolio manager since these entities must balance the need for profitability with the imperative of preserving capital to meet future liabilities.
Institutional investors' investment approaches are typically conservative compared with individual investors, focusing on long-term stability, capital preservation, and meeting future obligations. Indeed, each type of institutional investor has distinct strategies and objectives, but all share the common goal of responsibly managing large pools of capital to meet the needs of their stakeholders.
Passive vs. Active Management
Portfolio management can be either passive or active.
Active vs. Passive Portfolio Management
Active Management
Approach: Hands-on
Cost Implications: More costly
Performance: Historically, over long periods, underperforms
Passive Management
Approach: Hands-off
Cost Implications: Less costly
Performance: Historically, over long periods, performs like the market
Passive management is the set-it-and-forget-it long-term strategy. It may involve investing in one or more ETFs. This is commonly referred to as indexing or index investing. Those who build indexed portfolios may use modern portfolio theory to help them optimize the mix.
Active management involves attempting to beat the performance of an index by actively buying and selling individual stocks and other assets. Closed-end funds are generally actively managed, as are many mutual funds. Active managers may use any of a wide range of quantitative or qualitative models to aid in their evaluation of potential investments.
Active Portfolio Management
Investors who use an active management approach have fund managers or brokers to buy and sell stocks in an attempt to outperform a specific index, such as theStandard & Poor's 500Index or the Russell 1000 Index. Often, these investors will also use portfolio management software to help them track their investments.
An actively managed investment fund has an individual portfolio manager, co-managers, or a team of managers actively making investment decisions for the fund. The success of an actively managed fund depends on a combination of in-depth research, market forecasting, and the expertise of the portfolio manager or management team.
Portfolio managers engaged in active investing pay close attention to market trends, shifts in the economy, changes to the political landscape, and news that affects companies. This data is used to time the purchase or sale of investments to take advantage of market irregularities. Active managers claim that these processes will boostthe potential for returns higher than those achieved by simply tracking the holdings on a particular index.
Trying to beat the market inevitably involves market risk. Indexing eliminates this particular risk, as there is less probability of human error in selecting the index stocks. Index funds are also traded less often, which means that they incur lower expense ratios and are more tax-efficient than actively managed funds.
Passive Portfolio Management
Passive portfolio management, also referred to asindex fundmanagement, aims to duplicate the return of a particularmarket indexor benchmark.Managers buy the same stocks that are listed on the index, using the same weighting that they represent in the index.
A passive strategy portfolio can be structured as an ETF, a mutual fund, or aunit investment trust. Index funds are branded as passively managed because each has a portfolio manager whose job is to replicate the index rather than select the assets bought or sold.
Management feesassessed on passive portfolios or funds are typically far lower than active management strategies.
Discretionary vs. Non-Discretionary Management
Another critical element of portfolio management is the concept of discretionary and non-discretionary management. This portfolio management approach dictates what a third-party may be allowed to do regarding your portfolio.
A discretionary or non-discretionary management style is only relevant if you have an independent broker managing your portfolio. If you want the broker to execute trades that you have explicitly approved, you must opt for a non-discretionary investment account. The broker may advise you on strategy and suggest investment moves. However, without your approval, the broker is simply an advisor who must follow your instructions.
Meanwhile, some investors would prefer placing all the decisions in the hands of their broker or financial manager. In these situations, the financial advisor can buy or sell securities without the approval of the investor. The advisor still has a fiduciary responsibility to act in their client's best interest when managing their portfolio.
Key Elements of Portfolio Management
Asset Allocation
The key to effective portfolio management is the long-term mix of assets. Generally, that means stocks, bonds, and cash equivalents such as certificates of deposit. There are others, called alternative investments, such as real estate, commodities, derivatives, and cryptocurrency.
Asset allocation is based on the understanding that different types of assets do not move in concert, and some are more volatile than others. A mix of assets provides balance and protects against risk.
Investors with a more aggressive profile weigh their portfolios more toward volatile investments such as growth stocks. Investors with a conservative profile weigh their portfolios toward stabler investments such as bonds and blue chip stocks.
Rebalancing captures recent gains and opens new prospects while keeping the portfolio in line with its original risk-return profile.
Diversification
The only certainty in investing is that it is impossible to always predict winners and losers. The prudent approach is to create a basket of investments that provide broad exposure across different assets.
Diversification involves spreading the risk and reward of individual securities within an asset class, or between asset classes. Because it is difficult to know which subset of an asset class or sector is likely to outperform another, diversification seeks to capture the returns of different sectors over time while reducing volatility.
Real diversification is made across various classes of securities, sectors of the economy, and geographical regions.
Rebalancing
Rebalancing returns a portfolio to its original target allocation at regular intervals, usually annually. This is done to reinstate the original asset mix when the market movements push it out of kilter.
For example, a portfolio that starts with a 70% equity and 30% fixed-income allocation could, after an extended market rally, shift to an 80/20 allocation. Investors have made a good profit, but the portfolio now has more risk than investors with that balance can tolerate.
Rebalancing generally involves selling high-priced securities and putting that money to work in lower-priced and out-of-favor securities. The annual rebalancing exercise allows investors to capture gains and expand their chances for growth in high-potential sectors while keeping the portfolio aligned with the original risk-return profile.
Tax-Efficiency
A potentially material aspect of portfolio management relates to how your portfolio is shaped to minimize taxes in the long term. This is relevant for retirement accounts, how long securities are held on for, and which securities are held.
For example, certain bonds may be tax-exempt. This means that any dividends earned are not subject to taxes. Meanwhile, consider how the IRS had different rules relating to short-term or long-term capital gains taxes. For individuals earning less than $41,675 in 2023, their capital gains rate may be $0. Meanwhile, a short-term capital gains tax of 15% may apply if your income is above this IRS limit.
Portfolios include investments across cash accounts, 401(k)s, IRAs, and other retirement accounts.
Common Portfolio Management Strategies
Every investor's specific situation is unique. Therefore, while some investors may be risk-averse, others may be inclined to pursue the greatest returns (while also incurring the greatest risk). Very broadly speaking, here are several common portfolio management strategies an investor can consider:
- Aggressive: An aggressive portfolio prioritizes maximizing the potential earnings of the portfolio. Often invested in riskier industries or unproven alternative assets, an investor may be willing to risk losses. Instead, investors are looking for a "home run" investment by striking it big with a single investment.
- Conservative: Meanwhile, a conservative portfolio relates to capital preservation. Extremely risk-averse investors may adopt a portfolio management strategy that minimizes growth but also minimizes the risk of losses.
- Moderate: A moderate portfolio management strategy blends an aggressive and conservative approach. In an attempt to get the best of both worlds, a moderate portfolio still invests heavily in equities but also diversifies and may be more selective in what those equities are.
- Income-oriented: Often the option of choice for retired investors, this is for those who wish to live in part off their portfolio returns. These returns could come from bond coupons or dividends.
- Tax efficiency: As discussed above, investors may be inclined to focus primarily on minimizing taxes, even at the expense of higher returns. This may be especially important for high earners who are in the highest income tax bracket. This may also be a priority for young investors who have a very long way until retirement. By getting started with a Roth IRA, these investors can grow their portfolio over time and face no federal taxes on these funds when they retire.
The Retirement Security Rule
When building and managing investment portfolios, it's crucial to understand the regulatory environment that governs financial advice. One significant aspect of this landscape is the Department of Labor's April 2024 fiduciary rule, known as the Retirement Security Rule, which has been undergoing legal challenges since its introduction. Slated to take effect in September 2024, the legal process has paused that for now.
In July 2024, two Federal District Courts in Texas issued orders staying the effective date of the new fiduciary rule. This rule was set to redefine when a financial professional is considered a fiduciary under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code regarding when people provide advice for retirement accounts such as 401(k)s and IRAs.
The rule is intended to protect investors from conflicts of interest over their retirement accounts. Specifically, the rule states that a financial services provider must act as an investment advice fiduciary if any of the following applies:
- They make investment recommendations to an investor related to retirement;
- The recommendation is provided for a fee or other compensation; or
- The provider states that they are acting as a fiduciary or makes the recommendation in a way that would lead a reasonable investor to believe that they make the recommendation based on the investor's best interest.
Due to the court stays, the financial services industry remains subject to the previous five-part test from a 1975 DOL regulation. Under this standard, professionals are considered a fiduciary when providing investment advice if they meet all the following criteria:
- Renders advice: The individual renders advice as to the value of securities or other property, or makes recommendations on investing in, purchasing, or selling securities or other property.
- Regular basis: The advice is provided on a regular basis.
- Mutual agreement: There is a mutual agreement, arrangement, or understanding with the plan or a plan fiduciary that the advice will serve as a primary basis for investment decisions.
- Individualized advice: The advice is individualized based on the particular needs of the plan.
- Primary basis for decisions: The advice will serve as a primary basis for investment decisions.
This standard has been criticized for being too narrow, potentially allowing some financial professionals to avoid fiduciary responsibility even when providing important investment recommendations. The new DOL fiduciary rule, stayed by the court orders, would significantly broaden the scope of who is considered a fiduciary when providing investment advice.
Unlike the five-part test, the new standard would consider a much wider range of recommendations as fiduciary advice, including one-time recommendations such as those for IRA rollovers. It would eliminate the "regular basis" and "mutual agreement" requirements, meaning that even a single instance of advice could trigger fiduciary status.
The new rule would also expand the types of compensation that could create conflicts of interest, requiring more financial professionals to follow the fiduciary standard when recommending products or services for retirement accounts. This change aims to provide stronger protections for retirement savers by ensuring that more financial professionals are legally obligated to act in their clients' best interests, particularly in scenarios like rollover recommendations that can have significant long-term impacts on retirement savings.
For individual investors, this development underscores the importance of understanding the nature of their relationship with financial advisors. It's crucial to know whether your advisor is acting as a fiduciary and what standards of care they are required to meet when providing investment advice, particularly for retirement accounts.
Challenges of Portfolio Management
Whatever strategy is chosen, portfolio management always faces several hurdles that often can't be eliminated entirely. Even if an investor has a foolproof portfolio management strategy, investment portfolios are subject to market fluctuations and volatility. The best management approach can still suffer from significant losses.
Though diversification is an important aspect of portfolio management, it can also be challenging to achieve. Finding the right mix of asset classes and investments to balance risk and return requires an in-depth understanding of the market and the investor's risk tolerance. It may also be expensive to buy a wide range of securities to meet the desired diversification.
To devise the best portfolio management strategy, an investor must first know their risk tolerance, investment horizon, and return expectations. This requires a clear short-term and long-term goal. Because life circ*mstances can quickly and rapidly change, investors must be mindful of how some strategies limit liquidity or flexibility. In addition, the IRS may change tax regulations, forcing you to change your investment strategy.
Lastly, portfolio managers charge fees. The portfolio manager must often meet specific regulatory reporting requirements, and managers may not have the same views of the market as you do.
How Do I Determine My Risk Tolerance?
Determining your risk tolerance involves assessing your willingness and ability to endure market volatility and potential losses. This can be influenced by your financial goals, investment time horizon, income, and personal comfort with risk. Tools like risk tolerance questionnaires can help quantify your risk tolerance by asking about your reactions to hypothetical market scenarios and your investment preferences. In addition, thinking back to your past investment experiences and consulting with a financial advisor can provide a clearer understanding of the kinds of investments that are right for you in terms of your risk tolerance.
What Is Asset Allocation?
Asset allocation involves spreading the investor's money among different asset classes so that risks are reduced and opportunities are maximized. Stocks, bonds, and cash are the three most common asset classes, but others include real estate, commodities, currencies, and crypto. Within each of these are subclasses that play into a portfolio allocation.
What Should I Do If My Portfolio Has Significant Losses?
If this happens, it's important to avoid panic selling and instead assess the situation calmly. Start by reviewing your investment strategy to ensure it still aligns with your long-term goals and risk tolerance. Consider whether the losses are because of market volatility or fundamental changes in the assets you hold. Rebalancing your portfolio might be necessary to maintain your desired asset allocation. Diversifying your investments can also help mitigate future risks. Consulting with a financial advisor can give you guidance and help you make informed decisions about how to recover from your losses and adjust your strategy if needed.
How Do I Evaluate How My Portfolio Is Doing?
Evaluating the performance of your portfolio involves comparing its returns against benchmarks (typically indexes that offer a mix like you're aiming for in your portfolio) and considering your investment goals. Data to review include total return, your risk-adjusted return, and the performance of individual assets relative to their respective indexes. It's also important to review the consistency of your returns over time and whether your portfolio is making progress toward your objectives.
The Bottom Line
Anyone who wants to grow their money has choices to make. You can be your own investment portfolio manager, or you can hire a professional to do it for you. You can choose a passive management strategy by putting your money in index funds. You can also try to beat the markets by actively managing your portfolio.
You'll want to pay attention to the basics of portfolio management: pick a mix of assets to lower your overall risk, diversify your holdings to maximize your potential returns, and rebalance your portfolio regularly to keep the mix right.
