It is rare to find investors investing their entire savings in a single security. Instead, they tend to invest in a group of securities. Such a group of securities is called a portfolio. Most financial experts stress that in order to minimize risk; an investor should hold a well-balanced investment portfolio. The investment process describes how an investor must go about making.
Decisions with regard to what securities to invest in while constructing a portfolio, how extensive the investment should be, and when the investment should be made. This is a procedure involving the following five steps:
• Set investment policy
• Perform security analysis
• Construct a portfolio
• Revise the portfolio
• Evaluate the performance of portfolio
1. Setting Investment Policy
This initial step determines the investor’s objectives and the amount of his investable wealth. Since there is a positive relationship between risk and return, the investment objectives should be stated in terms of both risk and return.
This step concludes with the asset allocation decision: identification of the potential categories of financial assets for consideration in the portfolio that the investor is going to construct. Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds and cash.
The asset allocation that works best for an investor at any given point in his life depends largely on his time horizon and his ability to tolerate risk.
Time Horizon – The time horizon is the expected number of months, years, or decades that an investor will be investing his money to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable with a riskier or more volatile investment because he can ride out the slow economic cycles and the inevitable ups and downs of the markets. By contrast, an investor who is saving for his teen-aged daughter’s college education would be less likely to take a large risk because he has a shorter time horizon.
Risk Tolerance - Risk tolerance is an investor’s ability and willingness to lose some or all of his original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favour investments that will preserve his or her original investment. The conservative investors keep a "bird in the hand," while aggressive investors seek "two in the bush."
While setting the investment policy, the investor also selects the portfolio management style (active vs. passive management).
Active Management is the process of managing investment portfolios by attempting to time the market and/or select „undervalued‟ stocks to buy and „overvalued‟ stocks to sell, based upon research, investigation and analysis.
Passive Management is the process of managing investment portfolios by trying to match the performance of an index (such as a stock market index) or asset class of securities as closely as possible, by holding all or a representative sample of the securities in the index or asset class. This portfolio management style does not use market timing or stock selection strategies.
2. Performing Security Analysis
This step is the security selection decision: Within each asset type, identified in the asset allocation decision, how does an investor select which securities to purchase. Security analysis involves examining a number of individual securities within the broad categories of financial assets identified in the previous step. One purpose of this exercise is to identify those securities that currently appear to be mispriced. Security analysis is done either using Fundamental or Technical analysis (both have been discussed in subsequent units).
Fundamental analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer. It scrutinizes the issuer's income and expenses, assets and liabilities, management, and position in its industry. In other words, it focuses on the „basics‟ of the business.
Technical analysis is a method used to evaluate the worth of a security by studying market statistics. Unlike fundamental analysis, technical analysis disregards an issuer's financial statements. Instead, it relies upon market trends to ascertain investor sentiment to predict how a security will perform.
3. Portfolio Construction
This step identifies those specific assets in which to invest, as well as determining the proportion of the investor’s wealth to put into each one. Here selectivity, timing and diversification issues are addressed.
Selectivity refers to security analysis and focuses on price movements of individual securities. Timing involves forecasting of price movement of stocks relative to price movements of fixed income securities (such as bonds). Diversification aims at constructing a portfolio in such a way that the investor’s risk is minimized.
The following table summarizes how the portfolio is constructed for an active and a passive investor.
4. Portfolio Revision
This step is the repetition of the three previous steps, as objectives might change and previously held portfolio might not be the optimal one.
5. Portfolio performance evaluation
This step involves determining periodically how the portfolio has performed over some time period (returns earned vs. risks incurred).