If the year to date stock market has left us with any enduring lessons, it’s that asset return distributions can be significantly skewed and asymmetrical, but it is possible to manage the risk and control risk in a Portfolio (risk is defined as the volatility of daily returns.)
In this edition of Guest Post, QuantInsti discuss portfolio management, which, in my opinion is often misunderstood.
A Comprehensive Guide to Portfolio Management
Portfolio management is a technique of managing investment portfolios by analyzing the risk/return trade-offs of a portfolio as a whole and its underlying securities.
When it comes to trading, portfolio management is often used in rotation strategies. In these strategies, the trader will divide funds into various sectors of the market so that they can take advantage of any opportunities within that sector while avoiding over-investing in one sector.
What is a Portfolio?
A portfolio is an investment vehicle that makes up of two or more types of financial instruments. A portfolio is a collection of assets that a trader or trading firm holds and a portfolio’s assets may take many different shapes, including stocks, bonds, commodities, or derivatives.
Risk tolerance and investment strategy are crucial elements in how a portfolio is being constructed, a portfolio will reflect the trader who owns it.
A portfolio made consisting of many prominent stocks, bonds, or index funds with limited short-term buying and selling may be the choice of an investor seeking long-term gains with little risk. A day trader’s portfolio, which can include long and short leveraged derivatives or currency trades, would experience much more turmoil.
What is Portfolio Management?
Portfolio management is about deciding what to buy when to buy it, and how much to invest in each security or asset class. It involves selecting securities or assets based on your individual goals, expectations and risk tolerance.
The word portfolio management is used to broadly describe how a manager handles a portfolio of assets.
There are a variety of assets available in the financial markets, including stocks, corporate bonds, treasury bills, commodities, foreign exchange, indices, options, and much more. Thus, it is essential to use management approaches to oversee asset portfolios that can put boundaries around important factors like risk and projected return.
Unfortunately, we cannot have infinite returns and zero risks since they are interdependent. If we want to raise the return on our portfolio, we must take on more risk.
Usually, portfolios are managed by qualified Portfolio Managers.
What does a Portfolio Manager do?
A portfolio manager is an individual who handles and oversees the investments of a company. They are responsible for investing and allocating funds to balance risk and returns across several areas.
The role of the portfolio manager aims to maintain the desired balance and risk profile of the investor’s investment. In quantitative portfolio management, portfolio managers and quants construct their portfolio quantitatively, generate returns and manage risks effectively.
Different investors might have different portfolios, depending on the types of securities they have purchased. A person who invests in bonds might have their money invested in different bonds, while someone who invests in stocks might invest in many different companies. Investors with more money to invest may have portfolios that include mixed assets like stocks and bonds, as well as things like real estate or art collections.
Why do people do Portfolio Management?
The purpose of a trading portfolio is to protect against losses in part of the portfolio and to diversify risk. A well-diversified portfolio can protect against unanticipated risks and lead to higher returns over time.
The most important aspect of developing a profitable portfolio is diversifying the investments while maintaining an appropriate level of risk.
Diversification can be achieved by investing in many asset classes with different degrees of risk, such as stocks, bonds, real estate and cryptocurrencies.
Types of Portfolio Management
There are two main types of portfolios in trading: passive and active portfolios.
1. Passive Portfolios
Passive portfolios are managed by professional investors or investment advisors, generally have lower management fees than active management due to their more straightforward approach and may not be subject to certain taxes such as short-term capital gains tax.
2. Active Portfolios
Active portfolios are also managed by professional investors or investment advisors and are likely to have higher management fees. Active portfolios attempt to outperform passive ones to generate a greater return on investment.
Assets classes in Portfolio Management
The three primary asset types have been equities or stocks, fixed income or bonds, and cash equivalents or money market instruments.
Today, the majority of investment professionals combine many asset classes into their portfolios, including stocks, bonds, commodities, futures, financial derivatives, real estate, etc.
Stocks or Equities: Since stocks are thought to carry a high level of risk, they present chances for high rewards. They can also be divided into subgroups based on the nation, industry, and/or asset of value or growth. The former are more likely to pay dividends, while the latter is less likely to do so but often yield better returns than the market. Additionally, since the shareholders own the company, they provide rights at shareholders’ meetings.
Bonds: Bonds have the advantage of having predictable investment returns from the start because they are low risk and deliver moderate returns. These assets are loans given to businesses and governments with pre-determined maturity dates and preset return or coupon payments. Depending on the maturity date, rating, and other factors, they can also be divided into corporate or government bonds.
Cash: The cash in our portfolio won’t always be invested entirely; on occasion, it may be utilised to conduct transactions in the money market, where the risk can range from extremely low to very high, based on the chosen currency.
Derivatives and Portfolio Management
On the other hand, there are derivative products in which, as their name implies, the value (and therefore the return) is derived from an underlying product.
Futures
In futures trading, one party buys or sells an asset with a pre-determined delivery date, and the other party sells or purchases the asset. The clearinghouse hereby guarantees this deal.
Given that the price was pre-determined at the time of the transaction, both parties are obligated to deliver the goods upon maturity regardless of their current market value and to accept it upon maturity.
However, it should be made clear that since traders typically hold speculative holdings, they rarely keep the contract open until its maturity date.
The future price is based on an underlying asset, such as an index of stocks or a commodity.
Options
Options are contracts in which one party purchases the right to buy or sell an asset at a defined price on a specific date, and the other party sells that right by committing to the transaction. The clearinghouse guarantees the transaction. The underlying asset, such as stocks, stock indices, commodities, etc., determines the option price.
Options are instruments that fall under the derivatives category in options trading, which means that their prices are generated from other things, typically stocks. An option’s pricing and the price of the underlying stock are inextricably linked.
Besides the specific range of financial instruments available, other considerations, such as volatility, liquidity, information accessibility, and transaction costs, must be taken into account while choosing one or the other instrument.
Tips for good Portfolio Management
Many people find the idea of managing their portfolios intimidating. But it does not need to be that hard. Here are some key tips for you to use to maintain a healthy, balanced portfolio.
1) Do not let your portfolio become too big.
2) Keep your portfolio balanced by maintaining a diverse mix of stocks and funds.
3) Maintain a diversified mix of bonds, stocks, and funds.
4) Research companies before purchasing stock from them.
5) Buy individual stocks instead of mutual funds when possible.
6) Select a few (no more than ten) undervalued companies and buy into their stocks early.
Conclusion
With all these elements, it seems clear that we need a framework that facilitates portfolio management and helps us select the best assets for a given moment, delimiting the level of risk to be supported as well as establishing a return goal.
From the industry’s point of view, it is also important to have established standard indicators that allow the performance of a portfolio to be compared with the rest of the industry.
QuantInsti pioneer Algorithmic Trading Research and Training Institute, conducting professional programmes in the contemporary field of Algorithmic and Quantitative Trading. They provide innovation and solutions to bridge the gap between finance and technology in the changing phase of the industry. It serves individuals, businesses, exchanges, data providers, brokers and other technology providers to achieve their common goal of excelling in Quant & Algo trading. QuantInsti provides both paid and free services to the industry.”
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