LOS: 40 PORTFOLIO MANAGEMENT: AN OVERVIEW

A Portfolio Perspective on Investing

Why should investors take a portfolio approach instead of investing in individual stocks? Why put
all your eggs in one basket?
Portfolio theory is used to maximize an investment's expected rate of return for a given level of
risk or minimize the level of risk for a given expected rate of return.
For the purpose of investing, risk is defined as the variation of the return from what was expected
(volatility). It is represented by a measure such as standard deviation.
Diversification is used to reduce a portfolio's overall volatility. Building a portfolio out of many
unrelated (uncorrelated) investments minimizes total volatility (risk). The idea is that most assets
will provide a return similar to their expected return and will offset those in the portfolio that
perform poorly. The diversification ratio is the ratio of the standard deviation of an equally
weighted portfolio to the standard deviation of a randomly selected security.

The composition of a portfolio matters a great deal. Different portfolios have different risk-
return trade-offs.
Portfolio diversification does not necessarily provide the same level of risk reduction during
times of severe market turmoil as it does when the economy and markets are operating
normally.
The modern portfolio theory says that the value of an additional security to a portfolio
ought to be measured along with its relationship to all of the other securities in the
portfolio.

Investment Clients
There are different types of investment clients.
Different individual investors have different investment goals, levels of risk tolerance, and
constraints. Some seek growth while others may invest to get regular income.
An institutional investor's role is to act as a highly specialized investor on behalf of others.
There are many types of institutional investors.
A pension plan is a fund that provides retirement income to employees. It is typically considered
a long-term investor with high risk tolerance and low liquidity needs.

In a defined contribution plan, the employer agrees to contribute a certain sum each
period based on a formula. Only the employer's contribution is defined; no promise is made
regarding the ultimate benefits paid out to the employee. The employee accepts the
investment risk.
A defined benefit plan defines the benefits that the employee will receive at the time of
retirement. That is, the employer assumes the risk of the investment, and is responsible for
the payment of the defined benefits regardless of what happens in the investment.

An endowment or a foundation is an investment fund set up by an institution in which regular

withdrawals from the invested capital are used for ongoing operations. Endowments and
foundations are often used by universities, hospitals, and churches. They are funded by donations.
A typical investment object is to maintain the real value of the fund while generating income to
fund the objectives of the institution.
A bank typically has a very short investment horizon and low risk tolerance. Its investments are
usually conservative. The investment objective of a bank's excess reserves is to earn a return that
is higher than the interest rate it pays on its deposit.
Investments made by insurance companies are relatively conservative. Although the income
needs are typically low, the liquidity needs of such investments are usually high (in order for
insurance companies to pay claims).
Both the risk tolerance and the return requirement of mutual funds are predefined for each fund
and can vary sharply between funds. They are more specialized than pension funds or insurance
companies. Study Session 18 discusses mutual funds in more detail.
A sovereign wealth fund is a state-owned investment fund. There are two types of funds:
saving funds and stabilization funds. Stabilization funds are created to reduce the volatility of
government revenues, to counter the boom-bust cycles' adverse effect on government spending
and the national economy.
Steps in the Portfolio Management Process
Step One: The Planning Step
The first step in the portfolio management process is to understand the client's needs and develop
an investment policy statement (IPS).
The IPS covers the types of risks the investor is willing to assume along with the investment goals
and constraints. It should focus on the investor's short-term and long-term needs, familiarity with
capital market history, and investor expectations and constraints. Periodically the investor will
need to review, update, and change the policy statement.
A policy statement is like a road map: it forces investors to understand their own needs and
constraints and to articulate them within the construct of realistic goals. It not only helps investors
understand the risks and costs of investing, but also guides the actions of portfolio managers.
Step Two: The Execution Step
The second step is to construct the portfolio. The portfolio manager and the investor determine
how to allocate available funds across different countries, asset classes, and securities. This
involves constructing a portfolio that will minimize the investor's risk while meeting the needs
specified in the policy statement.
Step Three: The Feedback Step
The process of managing an investment portfolio never stops. Once the funds are initially invested
according to plan, the real work begins: monitoring and updating the status of the portfolio and
the investor's needs.
The last step is the continual monitoring of the investor's needs, capital market conditions, and,
when necessary, updating the policy statement. One component of the monitoring process is
evaluating a portfolio's performance and comparing the relative results to the expectations and
requirements listed in the policy statement. Some rebalancing may be required.
Pooled Investments