Essential Concepts in Portfolio Management

Portfolio management is the process of matching the return and risk characteristics of an investor’s portfolio with his or her desired financial objectives. While scientific and technical in nature, there is also an art to the portfolio management process.

Portfolio management is the process of matching the return and risk characteristics of an investor’s portfolio with his or her desired financial objectives. While scientific and technical in nature, there is also an art to the portfolio management process.

This article outlines the basic steps—from establishing financial goals to measuring returns—and key considerations that influence the portfolio management process.

Objective and Constraint Identification

Most investors enjoy selecting investments and are inclined to jump to this step right away, but defining financial goals always comes first. Knowing the endgame—investing for financial freedom in retirement, building and protecting wealth, funding education or other goals—sets up the rest of the process. Before deciding where to invest, a risk questionnaire is useful to further define an investor’s risk and return objectives and constraints on the investment process. Since investors typically choose portfolios with either too much or too little risk, match goals with investment choices is critical.

Capital Market Expectations

After defining goals and analyzing risk tolerance, capital market expectations (CMEs) are made. Created from scratch or taken from a third-party source, such as Ibbotson, CMEs are the expected return and risk for different asset classes. They are used in the mathematical analysis of how to allocate assets in a portfolio, based on an investor’s pre-specified goals.


Asset allocation is based on goals for return and risk as well as constraints, such as liquidity/cash flow needs, time horizon, tax and other unique circumstances. Once these are reviewed, implementation can begin. Based on how asset classes affect each other and the overall return and risk profile for the portfolio, a number of different asset classes are specified by the advisor, along with a targeted allocation range for each. While the portfolio is a collection of individual investments, a majority of portfolio variability is determined by asset allocation. This makes asset allocation a critical component in the portfolio management process.

An essential concept in asset allocation is the correlation among investments and asset classes. Correlation is a measure of how related two things are, with 1 meaning perfectly correlated and -1 being perfectly negatively correlated. With investments, if one stock always goes up 1 percent and another always goes down 1 percent, they have a perfect negative correlation of -1. By having investments that perform differently, the overall risk level (as measured by volatility) in the portfolio can be greatly reduced. By adding different investments with low correlation, the overall risk in the portfolio is reduced. This is why diversifying into international investments and other assets classes, which both derive return from different factors than domestic stocks, is so important in portfolio management.

Another important consideration is human capital, which is the present value of an investor’s future labor income. Although it cannot be traded, it may be the largest asset that anyone has and should be treated like any other asset class. To hedge against human capital risk, life insurance is an important consideration. Typically, human capital needs are higher earlier in life and, therefore, more life insurance should be used to offset the potential loss, especially for those with dependents.

Monitoring and Rebalancing

After implementing investment decisions, the final steps are monitoring and feedback. Monitoring includes the evaluation of return, risk and ensuring that the behavior of investments or investment managers is in line with original expectations. Traditionally, the measures for performance have been limited to percentage gain (return) and standard deviation (risk). However, these measures cannot be so simply stated when it comes to personal finance.

Portfolio performance should be based on the likelihood of achieving financial goals, not solely on the level of returns generated. This assessment method is often referred to as shortfall risk, and is more important and meaningful for the individual than is standard deviation. This can be done by conducting Monte Carlo analysis both before and during the investment process. Monte Carlo analysis is a statistical method that generates a wide array of investment outcomes, and highlights those that are most likely to occur. Using this analysis method better illuminates the likelihood of reaching financial objectives.

When investment values have significant changes, their allocation can deviate substantially from the range targeted in the asset allocation step. Returns are cyclical; one asset class may outperform one year but are in general are unlikely to continue to do so for an extended period of time, with a general return to the norm. This is why monitoring and rebalancing is important. In this case, rebalancing is referring only to adjusting portfolio values to the strategic asset allocation selected, and not because of changes in investment objectives or constraints. This can also apply to changes in life circumstances, such as change in job, cash flow requirements, time horizon, tax circumstances and more, which affect the objectives and constraints of the portfolio. Buy and hold has been a revered investment technique for years, but with the volatility in the stock market, this may not be the optimal strategy for all investors. Tax considerations and transaction costs make it preferable to limit trading activity, but periodic rebalancing is critical in portfolio management.

It is easy to look at the gross percentage that represents the return on a particular investment, but a variety of things can affect the net return and should not be overlooked. This includes trading costs, investment commissions and fees, and tax implications. By engaging in a high amount of trading, an investor may not be improving the performance of the portfolio, but trading costs will assuredly increase. As for mutual funds, their performance has not been materially different from the performance of the stock market. Therefore, the only thing that has separated their performance has been fees charged to invest in them. With a short-term gains rate roughly 20 percentage points higher than the rate charged on long-term investment gains, tax implications should also be a critical decision in the portfolio management process.

Keys to Remember

  • In order to successfully manage an investment portfolio, the advisor must clearly identify an investor’s objectives and constraints.
  • Portfolio management is an ongoing feedback process. It never stops, and changing market factors and personal investment preferences require advisors to regularly monitor market conditions and investor responses.
  • The concept of diversification and correlation cannot be overly stressed. Even by adding an investment that is more risky by standard deviation, it can help to increase return while reducing overall portfolio risk. The portfolio return and risk is the critical focus in investment planning.
  • Don’t forget about how human capital can affect the asset allocation process and how its value is tied to other investments in the portfolio.

The information contained in this article is not intended to be tax, investment, or legal advice, and it may not be relied on for the purpose of avoiding any tax penalties. Fingerlakes Wealth Management does not provide tax or legal advice. You are encouraged to consult with your tax advisor or attorney regarding specific tax issues.This article was written by Advicent Solutions, an entity unrelated to Fingerlakes Wealth Management. © 2012,2014 Advicent Solutions. All rights reserved.

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