Importance of Portfolio Management
Portfolio management refers to the art and science of investing and managing money. The money is invested in instruments like stocks, bonds, mutual funds and real estate.
Portfolio managers are experts in investing and managing money and provide investment solutions through ‘Portfolio Management Services’ or PMS in India.
In this article, we will discuss the importance of portfolio management and how it contributes towards your investment objectives.
Why is portfolio management important?
Portfolio management is the responsibility of the portfolio manager and requires input from you (the client). The portfolio manager’s skills and your input will result in successful portfolio management.
Broadly, portfolio management is important for two reasons:
- It helps in personalizing the portfolio to your financial goals
- It allows you to focus on and optimize crucial aspects like asset allocation, risk, cost of investing and liquidity
Let’s look at these one by one:
Personalize your investment portfolio
The portfolio management process starts with the portfolio manager understanding your financial goals and risk level.
This may involve a discussion with your portfolio manager or answering a questionnaire that gives your portfolio manager sufficient information to understand you.
Aspects your portfolio manager will try to understand:
- Your income details
- What is your annual income?
- Is it stable or expected to change drastically?
- Your assets
- Do you own one or multiple homes?
- What is their value and purpose?
- Your liabilities
- Have you taken loans?
- How much monthly EMI do you pay?
- Your financial dependents
- How many financial dependents?
- Your financial goals
- Do you have specific financial goals?
- How much money do you need for each of these goals?
Each portfolio manager has a different approach/set of questions. Some may ask for fewer or more details than others.
Optimize portfolio’s asset allocation
Once the portfolio manager has understood your goals and risk level, it will allow them to recommend an optimal asset allocation.
Asset allocation refers to how your capital/investment is allocated to different asset classes like equity, debt, cash, gold, real estate and others.
The reason asset allocation should take precedence over other aspects is because the asset allocation:
- Contributes 90% to your investment returns, as per research
- Helps align the portfolio risk with your comfort level
Here are the risk and returns associated with major asset classes:
Note: The risk and return matrix above is generic. There are certain instruments under each asset class that may have risk and return substantially different from the average instrument in the asset class.
Align portfolio risk with your comfort level
The portfolio risk is determined by the asset allocation and, to some extent, the portfolio manager's investment strategy.
The portfolio manager must use an investment strategy that you are comfortable with.
While there are many risk indicators in finance, the drawdown is the most relevant and easiest to understand.
Drawdown refers to the maximum loss an investment has suffered. It is measured as the difference between the peak portfolio value and the lowest portfolio value.
For example: Suppose you invest Rs. 1 lakh, and its value peaks at Rs. 1.5 lakh a year later. But a market crash causes the portfolio to hit its lowest value of Rs. 75,000.
Thankfully, the portfolio manages to reach the peak value of Rs. 1.5 lakh a few months later. The drawdown, in this case, is 50%, calculated as the percentage difference between peak and lowest portfolio values.
Drawdown answers a simple question - How much loss in your portfolio can you bear without panicking?
For some, the answer is 10%, while for some the answer is 50%.
So make sure you ask your portfolio manager the drawdown of the investment strategy they recommend. If you are not comfortable with it, you need a different strategy.
If you invest without a proper portfolio management process, you may never know the drawdown of the portfolio you hold, which can result in disaster during market crashes.
Note - There are many other metrics that can help you understand the riskiness of the investment portfolio/strategy. Drawdown is just one of them.
Minimize costs of investing
Warren Buffet has said..
“I think you pay too much attention to where the stock market is going. Pay little attention to costs, and not enough attention to taxes”
Most people focus on the returns, but what matters as much, if not more, is net returns. Net returns are what you generate after paying all the costs of investing - management and performance fees, transaction costs and taxes.
Your portfolio manager must work with you to minimize the costs of investing. If minimizing your costs of investing is not something your portfolio manager is fond of, it is time to find another portfolio manager.
The ideal portfolio manager will offer you affordable services and work towards lowering transaction costs and taxation to help you generate higher returns.
With a strong portfolio management process in place, the costs of investing can be addressed by the portfolio manager as well as the client.
Note - Some strategies like momentum investing are inherently inefficient from the cost perspective but may have some merit. It is important to understand such nuanced strategies that may not look cost efficient but can generate great net returns.
Keep your portfolio liquid
Portfolio liquidity refers to how quickly you can convert your portfolio into cash at a fair price. While most investors invest with a long-term view, life is unpredictable.
You may need money in emergencies; your investment portfolio could be the only source. In such cases, you want to avoid selling your assets at a loss to fulfill the emergency. This is possible only if your assets are liquid in the market.
If you need your portfolio to be liquid, it is important to tell your portfolio manager. The portfolio manager can adjust the investment strategy to accommodate higher liquidity, but that may have a trade-off, mainly regarding potential returns.
Without proper portfolio management, it is not possible to make adjustments that are required to keep your portfolio liquid.
Note - Having a relatively less liquid investment portfolio is okay if you have accounted for emergencies through insurance and have sufficient cash on hand.
Portfolio management is as important as the decision to invest.
A great portfolio management process ensures all crucial aspects of investing are optimized, and none are ignored. This, in turn, creates a great investing experience for you without negative surprises.