By Rohan Chinchwadkar
Managing a complex investment portfolio can be challenging for individual investors, especially if financial planning is not done in a systematic way. Many times, investors focus too much on specific questions like ‘which stock to pick’ or ‘when to buy/sell’ and end up with a portfolio which does not satisfy important financial needs.
Before creating an investment plan, two critical arrangements have to be made: cash reserve (to cover living expenses for a few months in case of an emergency like job layoff) and insurance (life, health and general insurance). Once cash reserve and insurance are in place, the investor can design and manage the investment portfolio by following a simple four-step portfolio management process.
The first step in the portfolio management process involves the construction of a policy statement. The policy statement specifies how much and which types of risk the investor is willing to take. The aim is to understand and articulate investment goals and constraints as accurately as possible. The first thing a good financial planner will do is make you think about your short-term, medium-term and long-term financial needs so that you can construct a clear policy statement. This is an extremely important step of the process since it ensures that the constructed portfolio will be customised to suit your needs. A well-defined policy statement also allows you to set a benchmark for portfolio evaluation in the future. You can measure the success of your investment strategy only if you are clear about what you need.
Investment goals are usually expressed in terms of risk (which the investor is willing to take) and return (which the investor expects). Goals should be SMART: specific, measurable, achievable, realistic and time-bound. “To make a lot of money” is not a well-defined goal. It is important to note that a careful analysis of the investor’s risk preferences should precede any discussion of return objectives.
Investment constraints can be of different forms: liquidity needs (how quickly you might need to sell assets and generate cash), time-bound (need return over a specific time period), tax concerns (capital gains, income tax), personal preferences (common example: no investments in alcohol or tobacco companies) and unique needs arising from your personal situation (husband-wife are both pilots so they should avoid buying stocks of airline companies).
The second step involves assessing the external financial and economic conditions and developing a point of view about the future. This assessment along with the investor’s needs (defined by the policy statement) will jointly determine the investment strategy. Since market conditions undergo significant changes over a period of time, they need to be monitored and appropriate changes have to be made in the portfolio to reflect future expectations. This step also helps in setting realistic investment goals and return expectations.
The third step is to construct the portfolio by implementing the investment strategy and deciding how to allocate capital across geographies, asset classes (like equity, debt, real estate and gold) and securities (stocks, bonds). The main objective of portfolio construction is to meet investor needs by taking the minimum possible risk. Different approaches can be used by investors and portfolio managers to construct portfolios. Traditional finance theory suggests that investors can build an optimal portfolio by focusing only on the risk and return characteristics of various securities. This approach usually recommends a highly diversified portfolio because it believes that markets are efficient and it is difficult for investors to select “winner” stocks. A more practical approach, especially for emerging markets which have significant market inefficiencies, involves a three-step process to select securities: macroeconomic analysis, industry analysis and company analysis (along with stock valuation). Investors who do not want to engage in selection of securities themselves can consider mutual funds and exchange-traded funds.
Continuous monitoring and evaluation
Once a portfolio is constructed, it is critical to continuously monitor investor needs and market conditions so that appropriate changes can be made to the policy statement and investment strategy, whenever necessary. It is also important to evaluate portfolio performance on a risk-adjusted basis and compare it with a suitable market benchmark. Investors should remember that this is an eternally ongoing process and they should revisit all the steps at regular intervals (maybe an annual review) to ensure that the portfolio gets realigned when investor needs and market expectations change.