What is a portfolio?
Looking for the official portfolio definition? In finance speak, a portfolio refers to a collection of investments or financial assets held by an individual, investment company, financial institution or hedge fund.
This grouping of financial assets can include everything from gold and property to stocks, bonds and cash equivalents. In essence, an investment portfolio acts as a big briefcase carrying all of these financial assets.
Where have you heard about a portfolio?
If you’ve ever made an investment, or taken advice regarding investments, it’s likely that the term ‘portfolio’ will have been mentioned, particularly when discussing the specific topic of risk tolerance and factors affected. These days, there are also a number of different websites offering online portfolio creation and management tools and advice such as Nutmeg, Morningstar and Invest.com.
What you need to know about a portfolio…
When developing a portfolio, it’s very important that the financial advisor assesses the investor’s risk tolerance to minimise exposure to market volatility. Where a risk-tolerant investor might suit adding small-cap growth stocks to aggressive large-cap growth stock positions alongside international investment opportunities, a conservative investor might prefer to build a portfolio with broad-based market index funds and large-cap value stocks. An investor should feel comfortable with his portfolio and investments, which is why assessing risk tolerance is paramount in every portfolio development.
Risk tolerance can be influenced by several different factors including age, portfolio size, income stability, financial strength and temperament. An investor’s risk tolerance can then have a great effect on a number of different factors including investment time frame, investment objectives and the actual size of the investment.
The art of mixing and matching investments and assessing the balancing risk against performance for individual and institutional investors is referred to as portfolio management. In portfolio management, strengths, weaknesses, opportunities and threats are determined in a bid to maximise return at the given risk level. Portfolio management can take two forms: passive and active. Passive management (also known as indexing or index investing) involves simple tracking of a market index, whilst active management involves attempting to beat the market return by managing portfolios based on investment research and decisions on individual holdings.
Asset allocation aims to balance risk and award and optimise an investor’s risk/return profile. This is done by applying a long-term view of assets with the understanding that different types of assets (for example, equities, fixed-income and cash and equivalents) are more volatile than others and will demonstrate different behaviour over time. Asset allocation can be managed by various different methods including equal weighting, risk weighting, risk parity, Jensen Index and the Treyner ratio. Asset allocation is one of the most important decisions that investors make, with risk tolerance playing a key factor in the process.
One of the key recommendations – particularly for first-time investors – is to diversify your portfolio. With a diversified portfolio, investment funds are diversified into different types of companies in a bid to avoid losing one’s entire net worth as a result of investing everything into a single type of stock. A diversified portfolio balances out the risks, protecting against sudden drops in the value of a single investment, unexpected events in a given sector or region and poorly performing investments in general. A diversified portfolio is split across a range of different asset classes and sectors, with investors often referring to the global industry classification standard (GICS) as a model for diversification. The GICS approach divides the economy into 10 different sectors: energy, utilities, financials, materials, industrials, healthcare, consumer staples, information technology, telecommunication services and consumer discretionary. Comparing the P/E ratio of different stocks is another common method of stock analysis and selection.
The portfolio return refers to the monetary return experienced by the investor and can be calculated through various methodologies including the quarterly or monthly money-weighted return method and the true time-weighted method. To truly evaluate a portfolio’s return or performance, the overall return must be compared to the required benchmark, which is used as a standard. A benchmark can be a popular index (for example, the S&P 500 or the Russell 2000 Index), but is often linked to what an investor hopes to achieve from their investment. By understanding an investor’s goals, the portfolio manager can make suitable investment decisions based on the investor’s goals and expectations and calculate portfolio return and performance accurately.
Portfolio weights also play a huge part in portfolio performance evaluations and analysis. In short, portfolio weight applies to the percentage of an investment portfolio held by a single asset. The weight of a portfolio can apply to several different methods including value, unit, cost, sectors and types of securities.
Preferred time horizon
When it comes to choosing an investment, it is extremely important for an investor to have an idea of their preferred time horizon. Time horizon refers to the length of time over which an investment is made before it is liquidated and can be anything from seconds to decades. Short-term investments tend to have a time horizon of less than three years, whereas long-term investments have a time horizon of a decade or more.
Investor’s goals play a huge role in determining an investment’s time horizon – for example, if an investor is looking to save for his retirement in five years or is looking to save money for a deposit in a house in three years’ time, the time horizons will be five years and three years respectively – therefore, a more conservative portfolio would be recommended, as there would be little time to make up any losses. On the other hand, a younger investor looking to invest his entire portfolio in stocks will have decades to play with and therefore can afford to have a more aggressive portfolio and ride out any market volatility.
Efficient and inefficient portfolios
Portfolios can also be efficient or inefficient depending on their expected return. An efficient portfolio is an investment portfolio offering the highest expected return for a given level or risk. An efficient portfolio can also be referred to as an optimal portfolio. In contrast, an inefficient portfolio is an investment portfolio that has a poor risk-to-reward ratio, with expected returns being too low in relation to the amount of risk taken.
According to the American economist Harry Markowitz’s Modern Portfolio Theory (MPT), an asset’s risk or return should be assessed by its effect on a portfolio’s overall risk and return. When expected returns are not met for a given risk level, or the risk required to attain a certain level of return is too high, a portfolio is said to be an inefficient portfolio. On the other hand, when a portfolio balances securities with the highest potential returns with acceptable degrees of risk, it is said to be an efficient portfolio.