One of the biggest challenges faced by individuals & institutions is to decide how to invest for future needs. For individuals, the goal might be to fund retirement needs. For institutions such as insurance companies, the goal is to fund future liabilities in the form of insurance claims. Regardless of the ultimate goal, all face the same challenges. To an investor, the question is, “should I analyze and invest in each security in isolation or take a portfolio approach.” By portfolio approach, we mean evaluating individual securities in relation to their contribution to the whole portfolio. There are many benefits of portfolio management as follows:
Benefits of Portfolio Management
Helps in Avoiding Disasters
Portfolio management helps an investor avoid disastrous outcomes that arise from otherwise investing in a single security. This can very well be illustrated by looking at an example. In the 1990s, Enron was one of the most respected companies in the USA. Suppose an investor had USD 1000 to invest and bought 11 shares of Enron in August 2000 at USD 90.75 per share. The total investment is USD 998.25. In December 2001, the value of that investment of USD 998.25 would be USD 2.86 as the share price of Enron had fallen from USD 90.75 each to USD 0.26. The investor directly went from 1000 dollars to 3 dollars. This is disastrous; now, imagine had the investment been 10,000 dollars or 100,000 dollars? This helps us understand the magnitude of the disaster.
To avoid such disasters, investors should never invest in only one security but should diversify their portfolios.
Helps in Reducing Risks
Avoiding disasters is important, but disasters are not as common as volatility in the securities market. Following the previous example, suppose the investor has USD 1000, and he would invest in it as follows:
|Purchase price in June 2013||No. of shares purchased||Total Investment Value in June 2013||Price in May 2018||Total Investment Value in May 2018|
|General Electric||USD 23.37||21||USD 490.77||USD 15.39||USD 323.19|
|Apple||USD 65.39||7||USD 457.73||USD 188.38||USD 1318.66|
|Total||USD 948.50||USD 1641.85|
|Profit over 5-years = USD 693.35 (1641.85 – 948.50)|
If we look closely, even though the share of General Electric is in a loss, overall, the investor has made a good profit over the 5 years. This is because the investor has diversified his portfolio. Had he invested only in General Electric, he would be making losses. Thus we can conclude that portfolio management helps reduce downside risk/standalone risk through diversification. Diversification acts as a shock absorber for a volatile market.
Optimal Allocation of Funds
Any investor has limited funds to invest and would like to maximize the returns on his investment. Portfolio management aids in maximizing these returns. A haphazard investment methodology – buying a few stocks here, some bonds there, some gold somewhere, is actually not a good investor behavior. Portfolio management theory gives investors a proper framework & many different calculation models to decide exactly how much returns they want and how to get them. This structured approach makes it easy to allocate the limited funds available & put them to optimum use.
There are a few drawbacks of portfolio management as follows:
Drawbacks of Portfolio Management
No Downside Protection
We must understand that even though portfolio management does help in reducing downside risk, it doesn’t provide complete downside protection. When we select investments to create a portfolio, we choose in a manner that there is structured classification. We will invest in different asset classes; even within asset classes, we will select different sectors as per our goals. For example, sometimes, a subset of assets will go up in value at the same time that another will go down in value.
An investor will select from both subsets to reduce risk. But there will be times, such as the great meltdown of 2009, when the market crashes and the entire portfolio will result in negative returns. There is no method in portfolio management to avoid such a scenario. Thus, we can say that portfolio management is a good tool when used in a normal or growing market, but it becomes a little obsolete during a downfall or crash.
Risk of Over-diversification
Over-diversification occurs when the number of investments in a portfolio exceeds the point where the marginal loss of expected return is greater than the marginal benefit of reduced risk. In other words, when adding individual investments to a portfolio, each additional investment lowers risk but also lowers the expected return. Any portfolio must only be diversified until a point where unsystematic risk becomes minimum. This is usually a matter of judgment of the investors, and many times investors fall at the risk of over-diversification. This leads to lower returns for the invested money. This pitfall in portfolio management actually erodes investor returns.
There are always going to be some drawbacks to every theory & model. It is important to assess that even with the drawbacks, how much a tool does helps us. Top of FormPortfolio management has been used since the 1930s and has given such good results over the years & it has become so common that even a layman understands when we talk about “portfolio.” Portfolio management is the base on which an investment strategy is built & the method is widely accepted by expert investment analysts, portfolio managers, fund managers & the like
Read the concept of Value Additivity to learn more.