Essay About Portfolio Management And Risk Tolerance Level

Portfolio Management and Diversification
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PORTFOLIO MANAGEMENT AND DIVERSIFICATION
Introduction:
Portfolio management is a conglomeration of securities as whole, rather than unrelated
individual holdings. Portfolio management stresses the selection of securities for
inclusion in the portfolio based on that securitys contribution to the portfolio as a
whole. This purposes that there some synergy or some interaction among the securities
results in the total portfolio effect being something more than the sum of its parts.
When the securities are combined in a portfolio, the return on the portfolio will be an
average of the returns of the securities in the portfolio. For example, if a portfolio
was comprised on equal positions in two securities, whose returns are 15% and 20%, the
return on the portfolio, will the average of the returns of the two securities in the
portfolio, or 17.5%. From this we will discuss the process of creating a diversified
portfolio. The diversified portfolio is a theory of investing that reduces the risk of
losing all your money when “all your eggs” are not in one basket. Diversification limits
your risk an over the long run, can improve your total returns. This is achieved by
putting assets in several categories of investments.
Portfolio Process:
The portfolio process is as follows:
1. Designing an investment objective;
2. Developing and implementing an asset mix;
3. Monitoring the economy and the markets;
4. Adjusting the portfolio and measuring the performance
Due to the intensity of each of the four items, we will be covering only the first two.
1. Investment Objective:
This topic is broad and contains three major divisions. They are foundation objectives,
constraints and major objectives.
Foundation Objectives: These objectives generally receive the most attention from
investors and are determined by thorough determination of your needs, preferences and
resources.
– Return – you need to determine whether you prefer a strategy of return maximization,
where assets are invested to make the greatest return possible while staying within the
risk tolerance level, or whether a required minimum return with certainty is preferable,
generating only as much return with emphasis on risk reduction.
– Risk – There are many ways to assess the risk tolerance of any particular investor,
from the least knowledgeable of investments to the very sophisticated investor. Besides
the risk you are willing to take, there must be a measure of the risk associated with
each security be considered for the inclusion in the portfolio. It is important to
recognize the difference between the risk of an individual security and the risk of the
portfolio as a whole. The risk of a portfolio is less than the average risk of its
holdings, your risk tolerance should be matched to the risk of the overall portfolio and
not to the risk of each security.
– Inflation – Although some degree of inflation protection is needed, the extent will
vary depending upon the time horizon and the goal of using the portfolio to generate
income for future cash consideration. Whereas, someone using a short term trading
strategy and interested in maximization of capital gains may concentrate less on this
factor.
– Time Horizon – The time horizon is the period of time from the present until the
major change in your circumstances. A good portfolio design will reflect this time
change. For example – at 25 years of age and normal retirement at age 60 does not
necessarily mean the time horizon is 35 years. Different events in your life can
represent the end of one time horizon and the beginning of a new time horizon and a need
for a complete rebalancing of your portfolio. These events could include finishing
university, purchase of a new home and many others beside retirement.
– Liquidity – In portfolio management this is the amount of cash and near-cash in the
portfolio. For liquidity purposes, if you are wealthy and risk tolerant you may choice to
have about 5% of your portfolio in cash, this does mean that the cash component will
never rise above 5% due to the market cycle. Whereas those who are risk adverse may
choice to have 10% or more in cash.
– Taxation – The level of taxation will determine the choices that are made in regards
to the choice of tax advantaged securities such as some limited partnerships as well as
the choice of tax deferral plans.
– Market timing – Your investment strategy could include the buy and hold approach or
the market timing approach of investment. Buy and hold means long holding periods through
various market cycles for long-term growth and income. Market timing involves