Portfolio Management And Diversification Essay Example For Students

Portfolio Management And Diversification Essay PORTFOLIO MANAGEMENT AND DIVERSIFICATIONIntroduction:Portfolio management is a conglomeration of securities as whole, rather than unrelated individual holdings. Portfolio management stresses the selection of securities for inclusion in the portfolio based on that security’s contribution to the portfolio as a whole. This purposes that there some synergy or some interaction among the securities results in the total portfolio effect being something more than the sum of its parts. When the securities are combined in a portfolio, the return on the portfolio will be an average of the returns of the securities in the portfolio. For example, if a portfolio was comprised on equal positions in two securities, whose returns are 15% and 20%, the return on the portfolio, will the average of the returns of the two securities in the portfolio, or 17.5%. From this we will discuss the process of creating a diversified portfolio. The diversified portfolio is a theory of investing that reduces t he risk of losing all your money when â€Å"all your eggs† are not in one basket. Diversification limits your risk an over the long run, can improve your total returns. This is achieved by putting assets in several categories of investments. Portfolio Process:The portfolio process is as follows:1. Designing an investment objective;2. Developing and implementing an asset mix;3. Monitoring the economy and the markets;4. Adjusting the portfolio and measuring the performanceDue to the intensity of each of the four items, we will be covering only the first two. 1. Investment Objective:This topic is broad and contains three major divisions. They are foundation objectives, constraints and major objectives. Foundation Objectives: These objectives generally receive the most attention from investors and are determined by thorough determination of your needs, preferences and resources. ? Return – you need to determine whether you prefer a strategy of return maximization, where assets are invested to make the greatest return possible while staying within the risk tolerance level, or whether a required minimum return with certainty is preferable, generating only as much return with emphasis on risk reduction. ? Risk – There are many ways to assess the risk tolerance of any particular investor, from the least knowledgeable of investments to the very sophisticated investor. Besides the risk you are willing to take, there must be a measure of the risk associated with each security be considered for the inclusion in the portfolio. It is important to recognize the difference between the risk of an individual security and the risk of the portfolio as a whole. The risk of a portfolio is less than the average risk of its holdings, your risk tolerance should be matched to the risk of the overall portfolio and not to the risk of each security. ? Inflation – Although some degree of inflation protection is needed, the extent will vary depending upon the time horizon and the goal of using the portfolio to generate income for future cash consideration. Whereas, someone using a short term trading strategy and interested in maximization of capital gains may concentrate less on this factor. ? Time Horizon The time horizon is the period of time from the present until the next major change in your circumstances. A good portfolio design will reflect this time change. For example – at 25 years of age and normal retirement at age 60 does not necessarily mean the time horizon is 35 years. Different events in your life can represent the end of one time horizon and the beginning of a new time horizon and a need for a complete rebalancing of your portfolio. These events could include finishing university, purchase of a new home and many others beside retirement. ? Liquidity In portfolio management this is the amount of cash and near-cash in the portfolio. For liquidity purposes, if you are wealthy and risk tolerant you may choice to have about 5% of your portfolio in cash, this does mean that the cash component will never rise above 5% due to the market cycle. Whereas those who are risk adverse may choice to have 10% or more in cash. ? Taxation The level of taxation will determine the choices that are made in regards to the choice of tax advantaged securities such as some limited partnerships as well as the choice of tax deferral plans. The Knife Essay? Equities – There are several different types of securities included in this asset class. The following are just a few of such securities: common shares, rights, warrants and options. The main purpose of this asset class is generate capital gains either through active trading or long term growth in value. There will also be cash from this section due to a dividend stream. The objectives and constraints that will have influence in this asset class are risk, return, time horizon and inflation to name a few. This account may also account for 15% to 95% of a diversified portfolio. 2. Asset Mix:The next step in the asset allocation process to determine the appropriate balance among the selected asset classes. To determine the appropriate asset mix you must know who you are and what you want out of your investment. A different mix would occur if you were young professional, a middle aged factory worker or a senior citizen. For example:? Young, single professional with medium investment, high risk tolerance and long time horizon may choose the following asset mix:Cash 5%Fixed Income 25%Equities 70%? Middle-aged factory worker, married, three children. With concerns about future employment and funding college education, with low investment knowledge and medium risk tolerance may choice the following asset mix:Cash 10%Fixed Income 40%Equities 50%? Senior citizen with no income other than government pension, with medium time horizon and low risk tolerance may choice the following asset mix:Cash 8%Fixed Income 62%Equities 30%When creating your diversified portfolio i t will need to be constructed within your own particular risk guidelines. Therefore it is important to manage risk within your portfolio. When managing risk there two types of risk to be cognizant of, they are:? Systematic or market risk This risk pertains to each capital market, which can be volatile. Therefore, when the stock market averages fall, most individual stocks fall and when interest rates rise nearly all-individual bonds and preferred shares fall in value. Systematic risk can not be diversified away; the more a portfolio becomes diversified, the more it ends up mirroring the market. ? Nonsystematic or security specific risk – This risk pertains to the risk that the price of a specific security or a specific group of securities will change in price to a different degree or in a different direction from the market as a whole. Diversifying among a number of securities can reduce nonsystematic risk. Both of these types of risk can be avoided when you correctly evaluate your risk guidelines and determine the maximum amount of risk that you are willing to handle. Conclusion: Once your portfolio has been established then next step in the management is to evaluate your portfolio’s performance. The success of your portfolio is determined by comparing the total rate of return of the portfolio to the average total return of comparable portfolios. It is essential to develop a system to monitor the appropriateness of the securities that comprise the portfolio and the strategies governing it. The process is twofold as it involves monitoring:? The changes in your goals, financial position and preferences;? Expectations in capital markets and individual companies;Remember that diversification is more than placing your eggs in different baskets. It is also making sure that all your baskets aren’t made from the same material. BibliographyReferences:Wall Street 101, www.familyint ernet.comLearning to Invest, www.learningtoinvest.comYour Money Coach, www.yourmoneycoach.comBusiness Essays