Portfolio construction refers to a process of selecting the optimum mix of securities for the purpose of achieving maximum returns by taking minimum risk.
A portfolio is a combination of various securities such as stocks, bonds and money market instruments. Diversification of investments helps in spreading risk over many assets; hence one must diversify securities in the portfolio to create an optimum portfolio and ensure good returns on portfolio.
There are two approaches to portfolio construction:
(A) Traditional Approach of Portfolio Construction
(B) Modern Approach of Portfolio Construction
Traditional Approach of Portfolio Construction
Under traditional approach, the financial plan of an individual is evaluated with regard to an individual`s needs in terms of income and capital appreciation and appropriate securities are selected to meet those needs. It consists of five steps which are:
(1) Analysis of constraints: It involves analysis of constraints of the investor within which the objectives will be formulated. The constraints may be decided on the basis of:
Income needs – Investors need for current income (to meet living expenses) and constant income (to offset the effect of inflation)
Liquidity needs – Investors preference for liquid assets
Safety of Principal – Safety of principal value at the time of liquidation
Time Horizon – Life cycle stage and investment planning period of the investor
Tax Consideration – Tax benefits of investing in a particular asset
Temperament – Risk bearing capacity of the investor
(2) Determination of objectives: It involves formulation of objectives within the given framework of constraints. Constraints reflect the risk bearing capacity and income requirements of the investor. Some common objectives of investors are:
Growth in Income
Preservation of Capital
(3) Selection of Portfolio: The optimum asset mix for an investor depends upon his investment objectives.Investment ObjectivesAsset MixCurrent Income60% in debt and 40% in equityGrowth in Income60% in equity and 40% in debtCapital Appreciation90% in equity and 10% in debtSafety of Principal90% in debt instruments with focus on short term debt instruments and 10% on equity
(4) Risk & Return Analysis: It involves analysis of risk and returns involved in following a particular course of action. Major risk categories that an investor can tolerate are determined and efforts are made to minimize these risks to get expected returns.
(5) Diversification: It involves assigning relative portfolio weights to different securities on the basis of which the portfolio is diversified. Diversification is done on the basis of investor`s need of income and his risk bearing capacity. Industries that correspond to specific goals of the investor are selected, out of which few companies from each industry are chosen on the basis of its growth, profits, dividend, R&D, expected earnings, goodwill etc. Finally, the number of different stocks required to give adequate portfolio diversification are selected and the number of shares of each stock to be purchased are determined depending upon the size of portfolio.
Modern Approach of Portfolio Construction
The modern approach of portfolio construction also known as Markowitz Approach emphasizes on selection of securities on the basis of risk and return analysis. The financial plan of an individual is audited in terms of risks and returns and efforts are made to maximize expected returns for a given level of risk.
Unlike traditional approach which considers an investors need for income or capital appreciation as basis for selection of stocks, the modern approach takes into account the investors needs in from of market return or dividend and his tolerance for risks as basis for selection of stocks. Returns are usually measured in terms of market return and dividend and form the basis of selection of stocks.
Ten to Fifteen stocks are selected after thorough analysis and expected risk and return is computed for each stock. Stocks with good return prospects are selected and funds are appropriately allocated among different stocks according to the portfolio requirements (risk & return) of the investor.
An investor may adopt an active or passive approach to manage his portfolio. Under passive approach, the investor holds the securities for a previously established holding period while an active approach involves continuous assessment of risk and return of securities and replacing low performing securities with high performing securities over time.