Definition of portfolio
The
term portfolio refers to any collection of financial assets. Portfolios may be
held by individual investors and/or managed by financial professionals, hedge
funds, banks and other financial institutions. It is a generally accepted
principle that a portfolio is designed according to the investor’s risk
tolerance, time frame and investment objectives. The monetary value of each
asset may influence the risk/reward ratio of the portfolio and is referred to
as the asset allocation of the portfolio. When determining a proper
asset allocation one aims at maximizing the expected return and minimizing the
risk.
term portfolio refers to any collection of financial assets. Portfolios may be
held by individual investors and/or managed by financial professionals, hedge
funds, banks and other financial institutions. It is a generally accepted
principle that a portfolio is designed according to the investor’s risk
tolerance, time frame and investment objectives. The monetary value of each
asset may influence the risk/reward ratio of the portfolio and is referred to
as the asset allocation of the portfolio. When determining a proper
asset allocation one aims at maximizing the expected return and minimizing the
risk.
Types of portfolios
The following are the
five (5) major types of portfolios:
five (5) major types of portfolios:
1. The aggressive
portfolio: An aggressive portfolio or basket of stocks
includes those stocks with high risk/high reward proposition. Stocks in the
category typically have a high beta, or
sensitivity to the overall market. Higher beta stocks experience larger
fluctuations relative to the overall market on a consistent basis. If your
individual stock has a beta of 2.0, it will typically move twice as much in
either direction to the overall market – hence, the high-risk, high-reward
description. Most aggressive stocks (and
therefore companies) are in the early stages of growth, and have a unique value
proposition. Building an aggressive portfolio requires an investor who is
willing to seek out such companies, because most of these names, with a few
exceptions, are not going to be common household companies. Keeping losses to a
minimum and taking profit are keys to success in this type of portfolio.
portfolio: An aggressive portfolio or basket of stocks
includes those stocks with high risk/high reward proposition. Stocks in the
category typically have a high beta, or
sensitivity to the overall market. Higher beta stocks experience larger
fluctuations relative to the overall market on a consistent basis. If your
individual stock has a beta of 2.0, it will typically move twice as much in
either direction to the overall market – hence, the high-risk, high-reward
description. Most aggressive stocks (and
therefore companies) are in the early stages of growth, and have a unique value
proposition. Building an aggressive portfolio requires an investor who is
willing to seek out such companies, because most of these names, with a few
exceptions, are not going to be common household companies. Keeping losses to a
minimum and taking profit are keys to success in this type of portfolio.
2. The defensive
portfolio: Defensive portfolios
do not usually carry a high beta, and usually are fairly isolated from broad
market movements. Cyclical stocks, on the other hand, are those that are most
sensitive to the underlying economic “business cycle.” For example,
during recessionary times, companies that make the “basics” tend to
do better than those that are focused on fads or luxuries. Despite how bad the
economy is, companies that make products essential to everyday life will
survive. Think of the essentials in your everyday life, and then find the
companies that make these consumer staple
products.
portfolio: Defensive portfolios
do not usually carry a high beta, and usually are fairly isolated from broad
market movements. Cyclical stocks, on the other hand, are those that are most
sensitive to the underlying economic “business cycle.” For example,
during recessionary times, companies that make the “basics” tend to
do better than those that are focused on fads or luxuries. Despite how bad the
economy is, companies that make products essential to everyday life will
survive. Think of the essentials in your everyday life, and then find the
companies that make these consumer staple
products.
3. The income
portfolio: An income portfolio focuses on making money
through dividends or other types of distributions to stakeholders. These
companies are somewhat like the safe defensive stocks but should offer higher
yields. An income portfolio should generate positive cash flow. Real estate investment trusts (REITs)
and master limited partnerships (MLP)
are excellent sources of income producing investments. These companies return a
great majority of their profits back to shareholders in exchange for favorable
tax status. REITs are an easy way to invest in real estate without the hassles
of owning real property. Keep in mind, however, that these stocks are also
subject to the economic climate. REITs are groups of stocks that take a beating
during an economic downturn, as building and buying activity dries up.
portfolio: An income portfolio focuses on making money
through dividends or other types of distributions to stakeholders. These
companies are somewhat like the safe defensive stocks but should offer higher
yields. An income portfolio should generate positive cash flow. Real estate investment trusts (REITs)
and master limited partnerships (MLP)
are excellent sources of income producing investments. These companies return a
great majority of their profits back to shareholders in exchange for favorable
tax status. REITs are an easy way to invest in real estate without the hassles
of owning real property. Keep in mind, however, that these stocks are also
subject to the economic climate. REITs are groups of stocks that take a beating
during an economic downturn, as building and buying activity dries up.
4. The speculative
portfolio: A speculative portfolio is the closest to a pure
gamble. A speculative portfolio presents more risk than any others discussed
here. Finance gurus suggest that a maximum of 10% of one’s investable assets be
used to fund a speculative portfolio. Speculative “plays” could be initial public offerings (IPOs)
or stocks that are rumoured to be takeover targets. Technology or health care
firms that are in the process of researching a breakthrough product, or a
junior oil company which is about to release its initial production results,
would also fall into this category.
portfolio: A speculative portfolio is the closest to a pure
gamble. A speculative portfolio presents more risk than any others discussed
here. Finance gurus suggest that a maximum of 10% of one’s investable assets be
used to fund a speculative portfolio. Speculative “plays” could be initial public offerings (IPOs)
or stocks that are rumoured to be takeover targets. Technology or health care
firms that are in the process of researching a breakthrough product, or a
junior oil company which is about to release its initial production results,
would also fall into this category.
5. The hybrid
portfolio: Building a hybrid type of portfolio means venturing
into other investments, such as bonds, commodities, real estate and even art.
Basically, there is a lot of flexibility in the hybrid portfolio approach.
Traditionally, this type of portfolio would contain blue chip stocks
and some high grade government or corporate bonds. REITs and MLPs may also be
an investable theme for the balanced portfolio. A common fixed income
investment strategy approach advocates buying bonds with various maturity
dates, and is essentially a diversification approach within the bond asset
class itself. Basically, a hybrid portfolio would include a mix of stocks and
bonds in a relatively fixed allocation proportions. This type of approach
offers diversification benefits across multiple asset classes as equities and
fixed income securities tend to have a negative correlation with one another.
portfolio: Building a hybrid type of portfolio means venturing
into other investments, such as bonds, commodities, real estate and even art.
Basically, there is a lot of flexibility in the hybrid portfolio approach.
Traditionally, this type of portfolio would contain blue chip stocks
and some high grade government or corporate bonds. REITs and MLPs may also be
an investable theme for the balanced portfolio. A common fixed income
investment strategy approach advocates buying bonds with various maturity
dates, and is essentially a diversification approach within the bond asset
class itself. Basically, a hybrid portfolio would include a mix of stocks and
bonds in a relatively fixed allocation proportions. This type of approach
offers diversification benefits across multiple asset classes as equities and
fixed income securities tend to have a negative correlation with one another.
Theories of portfolio management
The theory of portfolio
management describes the resulting risk
and return of a combination of individual assets. A primary objective of
the theory is to identify asset combinations that are efficient. Here,
efficiency means the highest expected rate of return on an investment for a
specific level of risk. The primary starting point for portfolio theory
requires an assumption that investors are risk averse. This simply means that
they will not consider a portfolio with more risk unless it is accompanied by a
higher expected rate of return. The following are the various theories of
portfolio management:
management describes the resulting risk
and return of a combination of individual assets. A primary objective of
the theory is to identify asset combinations that are efficient. Here,
efficiency means the highest expected rate of return on an investment for a
specific level of risk. The primary starting point for portfolio theory
requires an assumption that investors are risk averse. This simply means that
they will not consider a portfolio with more risk unless it is accompanied by a
higher expected rate of return. The following are the various theories of
portfolio management:
Risk aversion theory
Risk aversion is an investor’s general desire to
avoid participation in “risky” behaviour or, in this case, risky
investments. Investors typically wish to maximize their return with the least
amount of risk possible. When faced with two investment opportunities with
similar returns, good investor will always choose the investment with the least
risk as there is no benefit to choosing a higher level of risk unless there is
also an increased level of return.
avoid participation in “risky” behaviour or, in this case, risky
investments. Investors typically wish to maximize their return with the least
amount of risk possible. When faced with two investment opportunities with
similar returns, good investor will always choose the investment with the least
risk as there is no benefit to choosing a higher level of risk unless there is
also an increased level of return.
Insurance is a great example of investors’ risk aversion.
Given the potential for a car accident, an investor would rather pay for
insurance and minimize the risk of a huge outlay in the event of an accident.
Given the potential for a car accident, an investor would rather pay for
insurance and minimize the risk of a huge outlay in the event of an accident.
Markowitz portfolio theory
Harry Markowitz developed the portfolio model. This
model includes not only expected return, but also includes the level of risk
for a particular return. Markowitz assumed the following about an individual’s
investment behaviour:
model includes not only expected return, but also includes the level of risk
for a particular return. Markowitz assumed the following about an individual’s
investment behaviour:
·
Given the same level of expected
return, an investor will choose the investment with the lowest amount of risk.
Given the same level of expected
return, an investor will choose the investment with the lowest amount of risk.
·
Investors measure risk in terms
of an investment’s variance or standard deviation.
Investors measure risk in terms
of an investment’s variance or standard deviation.
·
For each investment, the investor
can quantify the investment’s expected return and the probability of those
returns over a specified time horizon.
For each investment, the investor
can quantify the investment’s expected return and the probability of those
returns over a specified time horizon.
·
Investors seek to maximize their
utility.
Investors seek to maximize their
utility.
·
Investors make decision based on
an investment’s risk and return, therefore, an investor’s utility curve is
based on risk and return.
Investors make decision based on
an investment’s risk and return, therefore, an investor’s utility curve is
based on risk and return.
The efficient
frontier theory
frontier theory
Markowitz’ work on an individual’s investment behaviour
is important not only when looking at individual investment, but also in the
context of a portfolio. The risk of a portfolio takes into account each
investment’s risk and return as well as the investment’s correlation with the
other investments in the portfolio. A portfolio is considered efficient if it
gives the investor a higher expected return with the same or lower level of
risk as compared to another investment.
is important not only when looking at individual investment, but also in the
context of a portfolio. The risk of a portfolio takes into account each
investment’s risk and return as well as the investment’s correlation with the
other investments in the portfolio. A portfolio is considered efficient if it
gives the investor a higher expected return with the same or lower level of
risk as compared to another investment.
Characteristics of a good
portfolio
portfolio
An efficient portfolio is
one that is well-diversified and adequately compensates you for risk. When it
comes to putting together an efficient investment portfolio, reducing
volatility is the name of the game. Experts advise diversifying your portfolio
by including stocks from different industries. The characteristics of an
efficient portfolio are determined by the following variables:
one that is well-diversified and adequately compensates you for risk. When it
comes to putting together an efficient investment portfolio, reducing
volatility is the name of the game. Experts advise diversifying your portfolio
by including stocks from different industries. The characteristics of an
efficient portfolio are determined by the following variables:
Diversification
Opinions vary as to how
many stocks it takes to create a diversified portfolio. Whatever number you
choose, your portfolio should hold a broad spectrum of stocks from different
industries. Pairing a high-flying technology stock with a utility company stock
is an example of diversification. The idea behind diversification is that when
one stock is down, the other stocks in the portfolio pick up the slack. You
will have to do your homework when it comes to stock picking. This means
researching the top three or four companies in each industry, reading financial
and analyst reports to understand the financial outlook for each company, and
picking the best company to add to your portfolio.
many stocks it takes to create a diversified portfolio. Whatever number you
choose, your portfolio should hold a broad spectrum of stocks from different
industries. Pairing a high-flying technology stock with a utility company stock
is an example of diversification. The idea behind diversification is that when
one stock is down, the other stocks in the portfolio pick up the slack. You
will have to do your homework when it comes to stock picking. This means
researching the top three or four companies in each industry, reading financial
and analyst reports to understand the financial outlook for each company, and
picking the best company to add to your portfolio.
Beta
Beta is a measure of risk.
Essentially, beta tracks a stock’s performance relative to the stock market. A
beta of 1 means that a stock is as risky as the market (i.e., holds an average
risk). So if the expected market return is 12 percent, a stock with a beta of 1
should produce the same return. A stock with a beta of 2 is twice as risky as
the market. If the market has an expected return of 10 percent, a stock with a
beta of 2 has an expected return of 20 percent. On the downside, the stock
could decline by 20 percent or more. In other words, a high-beta stock is very
volatile. You don’t have to include a high-beta stock in your portfolio unless
it also contains stocks with counterbalancing betas as an offset.
Essentially, beta tracks a stock’s performance relative to the stock market. A
beta of 1 means that a stock is as risky as the market (i.e., holds an average
risk). So if the expected market return is 12 percent, a stock with a beta of 1
should produce the same return. A stock with a beta of 2 is twice as risky as
the market. If the market has an expected return of 10 percent, a stock with a
beta of 2 has an expected return of 20 percent. On the downside, the stock
could decline by 20 percent or more. In other words, a high-beta stock is very
volatile. You don’t have to include a high-beta stock in your portfolio unless
it also contains stocks with counterbalancing betas as an offset.
Returns
Investors fret over
returns; namely, whether stock investments will produce expected returns. An
efficient portfolio is not only one that is adequately diversified, but also
produces the expected returns within an acceptable variance. To calculate
expected returns, you assign a weighted distribution of possible returns and
add the results together. For example, if you assign a 50 percent probability
of a stock producing a return of 15 percent, a 30 percent chance of returning
10 percent, and 20 percent chance of returning 5 percent, the expected return
for the stock is 11.5 percent.
returns; namely, whether stock investments will produce expected returns. An
efficient portfolio is not only one that is adequately diversified, but also
produces the expected returns within an acceptable variance. To calculate
expected returns, you assign a weighted distribution of possible returns and
add the results together. For example, if you assign a 50 percent probability
of a stock producing a return of 15 percent, a 30 percent chance of returning
10 percent, and 20 percent chance of returning 5 percent, the expected return
for the stock is 11.5 percent.
Compensating for risk
It is not heavily weight
your portfolio with stocks that are extremely volatile. In good years, your
portfolio will produce returns way above the market but, in lean times, produce
very poor results. There is nothing wrong with taking risk when investing, but
you should be adequately compensated for it. Therefore, another characteristic
of an efficient portfolio is that it compensates you for the level of risk you
take when you add a stock. So when you add a high-beta stock in your portfolio,
it is with the thought of boosting the portfolio’s overall return while
dampening the potential volatility inherent in the stock with other stocks in
the portfolio.
your portfolio with stocks that are extremely volatile. In good years, your
portfolio will produce returns way above the market but, in lean times, produce
very poor results. There is nothing wrong with taking risk when investing, but
you should be adequately compensated for it. Therefore, another characteristic
of an efficient portfolio is that it compensates you for the level of risk you
take when you add a stock. So when you add a high-beta stock in your portfolio,
it is with the thought of boosting the portfolio’s overall return while
dampening the potential volatility inherent in the stock with other stocks in
the portfolio.
References
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New York: McGraw-Hill
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The American Economic Review, Vol. 85,
No. 5 pp. 1088-1105
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