- Portfolio management is the creation of a pool of assets and investments.
- The ideal portfolio depends on the investor’s goals.
- Portfolios must weigh the tradeoff between expected returns and degree of risk.
- Holding assets with low correlations is a strategy for managing portfolio risk.
What Is Portfolio Management
Portfolio management is the strategy of creating and overseeing a portfolio of investments which is consistent with an investor’s financial goals. Instead of simply determining if an individual asset is a good investment, portfolio management involves assessing the combination of all the investments collectively over a period of time.
When assessing a portfolio, investors usually focus on the expected return and the risk. Higher expected returns are always better and lower risk is always better. However, these two metrics are often at odds with one another, and the relative importance of each depends on the investor and their goals.
The ideal portfolio depends on the investor’s goals. An investor with a high risk tolerance may be willing to allocate all or most of their portfolio to an asset like Bitcoin, if they are willing to accept short-term volatility in their portfolio. An investor with low risk tolerance would make allocations to very predictable assets, like bonds, even if their expected returns are much lower.
Some investors may have very high risk tolerances and be willing to accept large temporary fluctuations in the value of their investments. Typically, younger investors are more willing to accept risk. Investors who have disposable income may also be more risk-taking, since losses won’t affect their ability to buy necessities like food or housing.
As the investment horizon increases, investors often choose to accept more portfolio risk. Since markets typically recover in the long-run, a long-term investor can absorb short-term losses and allow investments to recover over several years.
Investors typically have a lower risk tolerance if they are older, less financially resiliant, or have a short investment horizon. People with short investment horizons dislike risk because they may realize losses if they need to sell their assets before the markets have a chance to recover. Investors who are retired, or may retire soon, may have a very specific budget and thus underperforming investments could negatively impact their standard of living. In that scenario, the investor may wish to diversify their portfolio.
Diversification is one of the most important ways an investor can minimize risk at the portfolio level. A diversified portfolio will have allocations to many different assets, and no individual asset will make up too much of the portfolio. This ensures that the portfolio retains most of its value even if a single asset declines significantly.
Proper diversification is not achieved with a mere cursory examination of the assets in a portfolio. Another important factor to consider is the correlation that assets may have with each other. If assets are highly correlated, their values are likely to move in sync, meaning they will lose value at the same time, undermining the value of diversification. Assets with low or negative correlations should be part of the same portfolio to maximize the benefits of diversification.
Assets that are very similar, such as equities in the same industry, will have very high correlations. Assets that do well in opposite conditions will be negatively correlated. For example, when oil prices go up, oil companies will have their share prices rise while airlines will have their share prices fall. Bitcoin has a low correlation with most assets, making it a great portfolio diversifier.
As the assets in a portfolio fluctuate in price, their portion of the total portfolio changes. In order to maintain appropriate risk, the portfolio will need to be periodically rebalanced. This may be done through an active strategy that trades on a regular basis, or a passive strategy which only updates positions every year or so.
Measuring Portfolio Success
In order to determine if a portfolio is well constructed, investors need a standardized way of measuring success. Portfolio returns are the metric of sucess for measuring historical performance. However, this neglects the risk profile of the portfolio, so it is less useful in trying to assess how the portfolio will perform in the future.
The efficient frontier is a commonly cited metric to determine if a portfolio is well constructed. A portfolio is considered efficient if its expected returns are as high as possible for its level of risk. A portfolio is inefficient if it could lower risk without lowering expected returns, or raise expected returns without raising risk. Along the efficient frontier, the optimal portfolio depends on the investor’s ideal risk tradeoff.
Notice: River Financial does not provide investment, financial, tax, or legal advice. The information provided is general and illustrative in nature and therefore is not intended to provide, and should not be relied on for, tax advice. We encourage you to consult the appropriate tax professional to understand your personal tax circumstances.