What is portfolio management?

Looking for a portfolio management definition? It’s the organisation of an investor’s financial assets to reduce risk and maximise return. This involves making calculated, informed decisions about investments and using trading strategies.

Where have you heard about portfolio management?

If you have an investment portfolio, you are likely to have been advised about the importance of portfolio management.

BNP Paribas was in the news at the start of 2017 for cutting €3 billion in risk-weighted assets from its loan portfolio. This led to the French bank being named ‘Credit portfolio manager of the year’ at the Risk Awards.

And you’ll often read in the business press and websites about the appointment of new heads of portfolio management at leading wealth management businesses. Here, for example, Reuters is reporting Sanlam UK’s appointment of Charlie Parker as head of portfolio management. These are high profile positions, and moves in the industry are much talked about.

What you need to know about portfolio management…

There are five main aspects to consider when managing your portfolio effectively:

• Risk tolerance – typically, the higher the risk, the greater the return. If you take big risks you may achieve big gains or big losses, but if you avoid risk completely you are unlikely to make any gains or losses. Your ideal portfolio should strike a careful balance of risk depending on your risk tolerance
• Performance measurement – setting benchmarks and measuring how your investments perform allows you to keep track of any errors and establish the risk-return ratio. If you employ a portfolio manager, remember to take into consideration their investment style in performance management of your portfolio
• Allocation of assets – assets move differently and have different levels of stability. Choosing a mix of assets can help to reduce risk and maximise return by weighing up volatility and investing accordingly
• Diversification  – the volatility of markets and the risk involved with investing can be mitigated by investing in various different securities, markets and economic sectors. This means that if one market crashes, you won’t lose all of your money
• Rebalancing – the market values of securities changes over time, affecting the return of your investments and their weighting in your portfolio. Regularly rebalancing your portfolio ensures you keep a good balance of risk and return by returning the asset weighting back to its initial level

You must also think very carefully about what kind of investing strategy you want to pursue. Broadly speaking there are three main types:

• An aggressive investing strategy. This is a portfolio management strategy that seeks to maximise returns by taking a relatively higher degree of risk. In an aggressive investment strategy, capital appreciation rather than income or safety of principal is the primary objective. This kind of strategy therefore has an asset allocation with a substantial weighting in stocks, and a far smaller allocation to fixed income and cash. Young adults with a high tolerance for risk are especially suited to an aggressive investment strategy, as their long investment horizon enables them to ride out market fluctuations better than investors with a short investment horizon.
• A balanced or moderate investing strategy. This is a portfolio allocation and management approach aimed at balancing risk and return. Portfolios like these tend to be equally divided between equities and fixed-income securities. While a balanced investing strategy seeks to balance risk and return, it does involve greater risk than strategies aiming at capital preservation or current income. So, a balanced investing strategy is a moderately aggressive approach, suitable for investors with a longer time horizon (over five years), with some risk tolerance.
• Conservative investing. This is a strategy for investors with low to moderate risk tolerance, that aims to preserve a portfolio's value by investing in lower risk areas such as fixed-income and money market securities, and often blue-chip or large-cap equities. Conservative investors who have low risk tolerance are often very uncomfortable with the stock market and want to avoid it completely. But while this strategy can protect against inflation, it won’t earn any value over time.

Portfolio managers

A portfolio manager is another of the most important factors to consider when looking at fund investing.  A portfolio manager is a person (or group of people) responsible for investing a fund's assets, driving its investment strategy and managing portfolio trading. A portfolio manager has great influence on a fund – he or she is usually an experienced investor, broker or trader with a sustained track record of success, so check their CVs.

A portfolio manager is either an active or passive manager. If a manager takes a passive stance, his investment strategy mirrors a particular market index. The index used as a benchmark is crucial, as an investor would expect to see similar returns over the long term. On the other hand, if a manager takes an active approach to investing, he or she is trying to consistently outperform average market returns. Here, the portfolio manager is extremely important, as his or her investment strategy directly generates the fund's returns.

Portfolio rebalancing

Another term you should become familiar with is portfolio rebalancing – the process of adjusting the weightings of a portfolio of assets. Rebalancing involves buying or selling assets in a portfolio from time to time, to maintain or restore the original desired level of asset allocation.

Your original target asset allocation might, for example, have been 60% stocks and 40% bonds. But if the stocks did well over the period, this could have increased the portfolio’s stock weighting to 75%. If that happens, the investor may decide to sell some stocks and buy bonds to restore the portfolio’s original 60/40 allocation.

It’s generally recommended that investors re-examine allocations at least once a year, to allow any portfolio rebalancing to be undertaken. Rebalancing gives investors the chance to sell high and buy low, taking gains from high-performing investments and reinvesting them in areas that haven’t yet experienced such growth. So, one answer to the question ‘what is portfolio management?’ is: regularly monitoring and revising your portfolio to optimise its outcome.

Value at risk

Now we come on to some technical aspects of portfolio management – the better acquainted you are with details like these, the more informed your judgments will be as an investor.

Value at risk (VaR) is a way of measuring the degree of risk in an investment, and is generally used by investment banks and financial industry regulators to work out how much an investment portfolio could potentially lose over a particular period of time. This helps them estimate the amount of assets needed to cover any losses that are suffered. Financial firms can apply VaR assessments to all sorts of investments – both specific ones and packages or portfolios – and it’s also a helpful way to gauge the risk exposure of a company as a whole.

So how do you measure VaR? It’s calculated from three figures: the total potential loss, the probability of that loss occurring, and the specific period for which the calculation is being made. Imagine that an investment bank has calculated that an asset has a 6% one-month VaR of 3%. This would mean there’s a 6% probability of the asset losing 3% of its value in a month. Looked at in a different way, that 6% monthly probability translates into odds of a 3% loss occurring on around two days a month.

CAPM model and CAPM formula

Another portfolio management tool that you might like to look at is the capital asset pricing model (CAPM), which offers a formula that calculates the expected return on a security based on its risk level. The CAPM formula is the risk-free rate plus beta of the security times the difference of the expected return on the market and the risk free rate:

Expected Return on the security = rf + β (rm – rf)

Rf = risk free rate
β = beta
rm = expected return on the market

The CAPM model, developed in the 1950s by American economist Harry Markowitz, is based on the notion that investors need compensation for risk and for the time value of money. In the CAPM formula, the latter is represented by what’s known as the risk-free rate, which tends to be the prevailing government bond yield. 

The second part of the CAPM formula gauges how much compensation the investor requires to accept extra risk. That’s determined through a risk measure (known as beta) which compares the asset’s expected return on the market with the market premium. 

The underlying assumption of the CAPM model is that the expected return on an investment portfolio or individual security equals the return on a risk-free security plus a risk premium – an additional sum that compensates the investor for the risk undertaken. According to CAPM, an investment is unwise if the expected return doesn’t achieve or exceed the required return. But of course, any formula is just a guide, and the final decision has to be the investor’s. 

Find out more about portfolio management…

There is a whole range of other related terms in our comprehensive glossary, that can build on what you have learnt about ‘what is portfolio management’, such as diversification, risk management  and shares.

You might be interested in doing a course in portfolio management. If so, Coursera can help point you towards some of the leading providers of such courses.