Basic Principles of Portfolio Management

Basic Principles of the portfolio investment process are given below:

1. It is the portfolio that matters:

Individual securities are important only to the extent that they affect the aggregate portfolio. For example, a security’s risk should not be based on the uncertainty of a single security’s return but, instead, on its contribution to the uncertainty of the total portfolio’s return.

In addition, assets such as a person’s career or home should be considered together with the security portfolio. In short, all decisions should focus on the impact the decision will have on the aggregate portfolio of all assets held.

2. Larger expected portfolio returns come only with larger portfolio risk:

The most important portfolio decision is the amount of risk which is acceptable, which is determined by the asset allocation within the security portfolio.

This is not an easy decision, since it requires that we have some idea of the risks and expected returns available on many different classes of assets. Nonetheless, the risk/return level of the aggregate portfolio should be the first decision any investor makes.

3. The risk associated with a security type depends on when the investment will be liquidated:

A person who plans to sell in one year will find equity returns to be more risky than a person who plans to sell in 10 years.

Alternatively, the person who plans to sell in 10 years will find one year maturity bonds to be more risky than the person who plans to sell in one year. Risk is reduced by selecting securities with a payoff close to when the portfolio is to be liquidated.

4. Diversification works:

Diversification across various securities will reduce a portfolio’s risk. If such broad diversification results in an expected portfolio return or risk level which is lower (or higher) than desired, then borrowing (or lending) can be used to achieve the desired level.

5. Each portfolio should be tailored to the particular needs of its owner:

People have varying tax rates, knowledge, transaction costs, etc. Individuals who are in a high marginal tax bracket should stress portfolio strategies which increase after-tax returns. Individuals who lack strong knowledge of investment alternatives should hire professionals to provide needed counseling.

Large pension portfolios should pursue strategies which will reduce brokerage fees associated with moving capital between equity and non-equity managers (for example, by using options on futures). In short, portfolio strategy should be molded to the unique needs and characteristics of the portfolio’s owner.

6. Competition for abnormal returns is extensive:

A large number of people are continuously using a large variety of techniques in an attempt to obtain abnormal returns larger than should be expected given a security’s risk.

Securities which are believed to be undervalued are bought until the price rises to a proper level, and securities which are believed to be overvalued are sold until the price falls to a proper level.

If the actions of these speculators are truly effective, security prices will adjust instantaneously to new information the efficient market theory (EMT) will be correct.

The extent to which EMT is correct as well as the extent to which one has unique information determiners whether a passive “investment” strategy or an active “speculative” strategy should be used.