The definition of portfolio management is the act of making investment decisions for an investment portfolio, either for oneself or someone else, in order to meet an investor's goals. Portfolio managers determine appropriate asset allocation, select investments, take steps to mitigate risk, and perform periodic portfolio maintenance.
What is portfolio management?
Portfolio management refers to the act of making decisions about an investment portfolio. And while there are numerous activities that could be a part of managing an investment portfolio, these are some of the main portfolio management activities:
- Determining an appropriate asset allocation
- Choosing a passive or active investment style
- Mitigating risk
- Rebalancing the portfolio
Portfolio management generally refers to these activities done by a professional, although many individuals choose to manage their own investments. Effectively managing your own portfolio requires a thorough understanding of investment instruments such as stocks and bonds, as well as the time needed to properly research investment choices and to perform maintenance activities such as rebalancing.
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Appropriate asset allocation
A major step in the portfolio management process involves determining an appropriate asset allocation strategy -- that is, how much of your portfolio should be in stocks and how much should be invested in fixed-income investments or bonds.
You can read our thorough discussion of asset allocation, but the general idea is that while stocks have the best potential for long-term returns, they also have the most short-term volatility, making them most suitable for younger investors. Fixed-income investments don't have quite as much return potential, but also tend to be less volatile and can create a steady income stream, making them more appropriate for older investors.
One general rule of thumb is that if you take your age and subtract it from 110, you can determine an appropriate stock allocation, as a percentage of your portfolio's assets. For example, if you're 40, this implies that 70% of your assets should be invested in stocks, with the rest in bonds.
Passive or active portfolio management
Once the appropriate asset allocation has been determined, the next step in portfolio management is to start thinking about which investments to choose.
One big decision you'll need to make is whether you want to passively or actively manage your portfolio. Passive management refers to using index funds as investment vehicles, in order to simply match the market's performance. Active management means that you're trying to beat the market.
As an example, if you determine that a portfolio with a 70% stock allocation is appropriate for you, a passive strategy might include investing in an S&P 500 index fund, a small-cap stock index fund, and a foreign stock index fund -- or a target-date fund, which can not only passively invest your money but also adjusts your asset allocation over time, could be a good choice.
On the other hand, an active management strategy might involve selecting 15-20 individual stocks to invest in or simply a handful of actively managed mutual funds.
Diversifying risk
As an investor, there are two main types of risk you need to worry about. Systematic risk refers to risks that affect your portfolio as a whole. Stock market crashes are an example of a systematic risk, as a crash tends to affect most stock investments, not just a few. Higher-than-expected inflation and interest rate changes are other examples of systematic risk.
The other type of risk is called unsystematic risk, which is also known as diversifiable risk. This refers to the risks that apply to your individual investments. For example, if you own Apple stock, the sales performance of the next iPhone is an example of an unsystematic risk that affects your portfolio.
While it's impossible to completely avoid risk when investing, one of the major objectives of portfolio management is to mitigate your risk. Systematic risk can be mitigated by practicing smart asset allocation strategies and by choosing some investments that help to offset systematic risk. For example, allocating some of your bond investments to inflation-protected bonds can help reduce your inflation risk. Choosing some stock investments that have a low beta, or low volatility, can help mitigate the risk associated with market crashed. Or, if you want to lower the risk of interest rates rising, you could create a bond ladder with your fixed-income investments.
On the other hand, diversifying your investments is the best way to mitigate your unsystematic risk. In other words, if Apple only makes up a small portion of your portfolio, it won't be devastating if iPhone sales come in weaker than expected. Investing in mutual funds or ETFs can be an effective way of diversifying, as can choosing a portfolio of a dozen or more stocks that operate in a variety of industries.
Maintaining the desired allocation and risk level
Finally, it's important to realize that portfolio management is truly an ongoing process. For one thing, you'll need to properly allocate your new investment capital over time and make sure that your portfolio remains well diversified.
Also, you'll need to check on your portfolio over time to make sure it's still properly allocated and make changes if necessary, a concept known as rebalancing.
Here's why this is so important. Consider a simplified example of a portfolio that contains four stocks -- for instance, Apple, ExxonMobil, Wells Fargo, and Berkshire Hathaway -- each of which initially makes up 25% of the portfolio.
Let's say that over the next year, Apple doubles in price, while the other three stocks stay right where they are. If this happens, Apple will now make up 40% of the portfolio, while the other three will only account for 20% each. In other words, your investment portfolio's performance is now highly dependent on Apple, so it would be a good idea to sell some of the position and add to the other three to rebalance your investments.
As I mentioned, this was a simplified example, but this is an important concept that can prevent your investment performance from becoming too dependent on any single stock, fund, or asset class.
Do-it-yourself or hire an advisor?
If you have the time, knowledge, and desire to manage your own investment portfolio, there's nothing wrong with doing so. If you're lacking in any of these three areas, it can be a smart idea to consult a financial advisor who can create and implement a portfolio management plan for you.
