In this lesson, you’re expected to learn about:
– portfolio management strategies
– the efficient market hypothesis
What is an investment portfolio?
An investment portfolio isn’t a physical thing or single entity. It is a collection of different investments treated as a single combination.
You can measure and analyze an investment portfolio as a single collection of different investments and do the same for each individual investment within a portfolio.
Portfolio management is the buying, selling and trading of investments within a portfolio – optimizing the returns of the portfolio by managing which investments the portfolio holds.
But the portfolio itself remains constant despite the changes of its exact contents. The portfolio changes only when the underlying investment strategy changes.
For this reason, organizations often have many investment portfolios. Each portfolio is managed using a unique strategy based on the goals of the investors.
For example, a company may have a stock investment portfolio that it uses to generate returns on petty cash, while also maintaining a capital investment portfolio that includes land, corporate acquisitions and subsidiaries and other types of capital.
Each of these portfolios has different contents and different purposes for existing, and the strategies involved in managing the contents are different as well.
Portfolio Management Strategies
1) Debt Portfolio
This type of investment portfolio invests exclusively in bonds of different types and with different maturity dates, usually with the intention of staggering maturity dates and coupon maturities in order to maintain regular cash flows.
2) Hedge Portfolio
It is intended to hedge other forms of risk by managing derivatives and diversifying investments. A portfolio like this changes based on the types or amount of risk the company is accepting.
3) Slush Fund / Petty Cash Portfolio
A company that maintains a cash account for irregular small payments that crop up from time to time can still generate a return on this cash by maintaining a portfolio of short-term, highly liquid investments.
Note: Throughout this lesson, we refer to stock investment portfolios but we’ll use the term ‘stock’ for the sake of consistency. You can include any type of investment – whether shares, bonds, capital or options – in an investment portfolio and analyze them using different methods.
Modern Portfolio Theory
Modern portfolio theory isn’t about how to value individual investments but instead how to assess the potential combinations between several investments. The relationship between two or more assets can change the balance of a portfolio’s total returns and the total risk involved.
Modern portfolio theory uses a number of mathematical formulae and modeling in an attempt to formalize a method of improving your understanding of investing.
Refers to setting up a portfolio to match the entire stock market or some well-known index as closely as possible. When established, these portfolios are simply left alone to fluctuate along with the indicator that the portfolio is set up to follow.
2) Active portfolio management
Involves regularly changing the contents of a portfolio. Every portfolio manger has his own strategies and methods for analyzing and optimizing returns but the point is that the portfolio manager is buying, selling and trading the underlying investments actively. He may try to take advantage of short-term fluctuations in price by making multiple trades every day.
The efficient market hypothesis states (incorrectly) that the market responds instantly to new information, ensuring that all investments and assets are valued at their fair market price.
According to the hypothesis, if people all have the same information at the same time and have equal access to exchange markets, prices adjust instantly to their economic equilibrium.
After all, not everyone has the same information; some people know more than others and many receive information at different times and process it in different ways. In addition, people don’t have equal access to exchanges.
The market is efficient only in the long term. In the short term, frequent and intense levels of volatility can push the value of an asset, investment or even an entire company well away from its real value.
Risk is an unavoidable part of corporate finance. If a company were to try to eliminate financial risk, all operations within the entire organization would come to a standstill.
Instead of trying to avoid risk, companies tend to make choices that have the biggest differential between risk and financial returns. They measure the amount of returns they expect on a potential investment and determine the potential costs associated with the risks of that investment. Then they use mathematical modeling to determine their best investment option.
A central tenet of modern portfolio theory is that a trade-off exists between risk and return. All things being equal, if a particular investment incurs a higher risk of financial loss for prospective investors, those investors must be able to expect a higher return in order to be attracted to the higher risk.
Just because an investor believes that a higher risk investment is going to generate higher returns doesn’t necessarily make it true. Sometimes higher-risk investments become less risky over time, attracting more investors who then drive up the price/value of the investment by competitively outbidding each other.
– how risk is assessed and the amount or expected returns, changes depending on the individual investor.
– investors will invest in higher-risk opportunities if they feel that doing so is going to generate higher returns.
It means taking advantage of differences in risk among your investments and the fact that investments tend to change in value at different times and even in different directions. So if your portfolio consists of several different investments and only one of them loses value, the portfolio loses a smaller percentage of its value than a single investment does.
To reduce risk by finding several investments that change in value at different times, in response to different events, by different percentages or in completely different directions.
In this way, you reduce the severity of any losses that may occur in a portfolio from the risk associated with only one investment. You can measure the effectiveness of portfolio diversification mathematically which we will cover later.
Warren Buffet, CEO of Berkshire Hathaway Inc., claims that diversification is used only when a company lacks confidence or ability, maintaining that diversification is a tool only for the incompetent. Thus, diversification simply for the sake of diversification isn’t very helpful. The point of diversification is to reduce the risk to your portfolio more than you reduce the returns.
Thus, you want to look for the best investments you can find and then diversify by purchasing those investments that provide the highest returns but risk losing value under directly opposite conditions.