What Is Portfolio Management?
Most people think of asset allocation when they think of what portfolio management involves. Asset allocation, how much of your money is long the stock market and long the bond market for instance, is certainly a component of portfolio management, but this topic is a lot broader than just that.
The reason why such a narrow view of portfolio management typically exists among investors and investment advisors is that certain very popular approaches are taken as givens, the fact that the proper way to invest is to buy a basket of stocks or look to mirror an index, and add in a certain percentage of long positions in various bonds.
This is hardly the only approach to investing though, and even though there are a number of variations of this standard approach, whether or not we should use this approach or the degree we should is much more of an open question.
Simply looking to use diversification with bonds exclusively in looking to manage the risk of stock market positions is certainly not the only way to manage risk, and portfolio management concerns all manners of looking to manage both returns and risk.
If we choose to invest that way, we are indeed making decisions about everything, including whether or not this is a good strategy, one that may best aspire to achieving one’s investment objectives according to one’s particular needs and goals.
In fact, in our example, the most fundamental decision as far as portfolio management that we are making here, by far, is choosing to be long the stock market and looking to diversify that, rather than the percentage that we use for this diversification.
If we just assume that this decision is the right one or the only reasonable one, this will certainly serve to overly limit our options, where a very dynamic process has been reduced to a far less meaningful one.
Lest we think that this view isn’t that prevalent, almost all of the effort put into portfolio management, in practice and even in theory, limits itself in this manner, but if we are truly looking to manage our portfolios this way, it is far better to understand portfolio management in its true broader sense, which is to look to optimize all factors involved in managing a portfolio efficiently.
Degrees of Participation
Merely deciding on the percentage of our portfolio that we wish to allocate to stocks and bonds is certainly a pretty simple and easy way to manage it, although ease should not be the primary goal here necessarily.
It’s not that ease of management isn’t a consideration, and it certainly can be with a lot of investors. This is exactly why mutual funds are so popular, and there’s nothing easier than owning a mutual fund long term, you just buy it and forget about it, or at least people can choose to do that.
For many investors, this might end up being the best approach for them, where the goal is to look to reduce and preferably eliminate all decisions related to portfolio management other than how much to invest over time.
The investment industry has done a fabulous job of steering people away from any real decision making, where they have cultivated beliefs that portfolio management is best left up to the professionals, and the professionals most often fail in both beating the market and managing risk properly, so what chances do average investors have?
This is why index funds have become more and more popular, as this seeks to simplify portfolio management a step further, where even the investments itself do not require any decisions beyond asset allocation decisions such as how much to have in bonds.
There are advantages in simplicity, but we at least need to consider how we might manage our portfolios effectively by playing a more active role in this management, whether or not we feel that we are or ever will be up to taking on the challenge.
The Two Main Considerations in Portfolio Management
Whenever we invest in something, there are two sides to the investment, which are risk and return. Both are important, and if anything, risk is even more important than return, although risk doesn’t really get the attention it deserves, especially from individual investors.
People focus way too much on what kind of return they can get from an investor and tend to turn a blind eye to some extent to the risk side of it, at least as long as the risks aren’t too obvious. When things go south, risks do become pretty plain, after one has suffered unacceptable losses that is.
This is not the time to start practicing sound risk management, as this is a lot like worrying about your house burning down after it is on fire. The time to worry about this is before the fire, to look to prevent the damage a fire might cause, not wait until it is ablaze and panic about it.
That describes the approach almost all individual investors take to risk management though, and they will ride bull markets and celebrate their earnings and good fortune, but become lost like a deer in headlights when things turn against them too much, like we saw with the 2007-2008 market crunch for instance.
Many investors ended up waiting until the market neared its bottom, where the pain become too much to bear, causing them to exit their positions at the worst possible time. These are the things that can happen when risk management is not utilized properly, and this is a pretty brutal example of poor portfolio management actually.
Of course, one must also pay attention to potential returns, although we don’t really do much of that either, instead being satisfied to capture whatever returns the market wishes to deliver us with our long positions.
The Goals of Proper Portfolio Management
The performance of our portfolios is entirely dependent on how we manage both returns and risk, and the performance itself, the probable performance of it, is reflected by how well we manage both, together.
Doing so properly will indeed involve us making decisions along the way, because this is what portfolio management is. The better our decisions, the better our portfolios will be expected to perform, on a balance of probabilities that is.
That’s really what we’re looking to do, to put ourselves in the best position we can, or at least strive to be in a good position, given the probabilities that are involved. This means that we’re looking to invest on what is more likely to happen than not, not according to what has actually happened.
This is a concept that few individual investors appreciate properly, the idea that when we make an investment we’re only looking to take advantage of probabilities. Nothing is ever certain with investments, but we don’t want to look at a particular investment and decide that it was good or bad depending on the results, we want to instead decide this based upon what the probabilities were.
One can lose on a particular investment in a single instance where the same strategy may have worked more often than not, and vice versa. Given that trading always involves probabilities, and one is always trading even when one chooses to just hold something come hell or high water, that’s a trading decision as well, then approaching investing on the basis of probabilities is an important matter indeed.
People do base their decisions somewhat on probability though, for instance with the idea that over the long-term stocks deliver good returns, but often don’t quite get that this has only really been true with very long-term time frames, and may not be even valid for the time frame that they are investing in.
There’s also the matter of efficiency, where even if a certain strategy has produced good results over time, another strategy may be more efficient and produce even better results. This is where looking to manage returns well comes in, and our goal in portfolio management is to at least seek out more efficiency, not just be satisfied with shooting for positive returns that may turn out to be quite mediocre.
Along the way, it is essential that we manage risk as well, such that we may strive for better returns while looking to better manage risk than a simple buy and hold strategy may deliver or may be expected to deliver.
Personal Versus Pooled Portfolio Management
This is what hedge funds do, they seek to both beat the market and do so in a way that involves less risk, and the ones that struggle, or worse, tend to pay less attention to risk management than they should.
Actively managing our own portfolios, beyond just deciding on things such as asset allocation or how much we need to contribute to the portfolio over time, is going to involve making some real decisions, decisions that will have a real impact on performance.
Whenever we take the ball and run with it ourselves, this may involve us making good decisions or poor ones, where we may score well or fumble the ball and end up on the ground. This does strike fear into the hearts of many individual investors, although these are the investors who really have no idea how to manage their own accounts anyway, and at least at this stage the fear may be well placed.
There is perhaps no more dangerous of an approach as an investor who may have tasted some success due to mere luck and then fancies himself or himself as proficient, only to discover later that he or she wasn’t so skilled, once the going gets tough. This can lead to some terrible decisions as the lack of proper risk management as well as other mistakes can be costly.
On the other hand, simply pretending that you can’t manage risk and being willing to bear the full brunt of market losses and approaching all this completely passively may not be a very good idea either, and this can lead to some huge losses as well, losses that perhaps could be minimized or even prevented by paying attention to risk more.
It does take some real skill to practice sound portfolio management, but these skills aren’t as unattainable as the investment industry wants you to believe. With a modest amount of effort and understanding, one can indeed manage one’s portfolio much better than just holding their investments or giving them over to funds who are very much handicapped with how they can manage your money.