Portfolio construction is the process of choosing the ideal combination of securities, such as stocks, bonds, mutual funds, and money market instruments, in order to maximise returns while assuming the least amount of risk or loss.
There are two well-known methods for porfolio construction : traditional and modern approaches.
Traditional Portfolio Construction Method
In this method, suitable securities are chosen to satisfy the client’s needs for income and capital appreciation after the financial plan has been assessed in light of those needs.
There are five fundamental steps in it:
- Constraints analysis: This entails analysing the investor’s constraints, under which the objectives will be formulated. The following criteria may be used to decide the constraints:
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- Income requirements – Investors want both steady and current income to cover living expenses (to offset the effect of inflation)
- For liquidity – The preference of investors for liquid assets
- Principal Safety – Protection of principal value at liquidation
- Time Horizon – The investor’s planning horizon for investments and life cycle stage
- Tax Benefits of Investing in a Specific Asset
- Temperament: The investor’s capacity for taking on risk
- Establishing objectives: It entails formulating goals within the restrictions that have been established. Constraints take into account the investor’s need for income and risk tolerance. Among investors’ common goals are:
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- Income growth from current levels.
- Capital Preservation and Appreciation.
- Since it is impossible to accomplish all goals at once, if a person wants to increase their capital, they must be willing to invest in securities with a high level of risk in order to do it.
- Portfolio Selection: An investor’s investing goals determine the best asset mix for him or her.
- Risk & Return Analysis: This involves examining the risks and potential rewards of adopting a certain course of action. In order to achieve the anticipated returns, efforts are made to reduce the major risk categories that an investor can endure.
- Diversification: This includes allocating relative portfolio weights to various securities in order to diversify the portfolio. Based on an investor’s requirement for income and his capacity for risk, diversification is carried out. Industries that meet a particular investor’s objectives are picked, and a small number of firms from each industry are chosen based on their growth, profits, dividends, R&D, predicted earnings, goodwill, etc. Finally, the number of different stocks needed to provide a sufficient level of portfolio diversification is chosen, and the amount of shares of each stock that must be purchased is decided based on the size of the portfolio.
Modern Portfolio Construction Methodology
The Markowitz Approach, a contemporary method of portfolio construction , places an emphasis on choosing assets based on risk and return analysis. In order to maximise predicted returns for a given degree of risk, an individual’s financial strategy is examined in terms of risks and returns.
In contrast to the traditional strategy, which uses an investor’s desire for income or capital growth as the basis for stock selection, the modern approach examines an investor’s needs for market return or dividends as well as his risk tolerance. Returns are often expressed in terms of market return and dividend, and they serve as the foundation for stock selection.
After careful consideration and computation of estimated risk and return for each investment, ten to fifteen stocks are chosen. According to the investor’s portfolio criteria (risk & return), investment options with strong return prospects are chosen, and funds are suitably distributed among various stocks.
An investor can manage and build his portfolio using an active or passive strategy. In a passive method, the investor retains the securities for a certain amount of time, whereas an active approach continuously evaluates the risk and return of the securities and gradually replaces underperforming stocks with high-performing ones. The investment environment can be very dynamic and constantly changing. However, individuals that take the time to comprehend the fundamental ideas and the many asset classes stand to benefit greatly in the long run. Learning how to differentiate between various investment types and which rung each one is on the risk ladder is the first step.
Different Asset Classes
With so many potential assets to include in a portfolio, investing may be a frightening proposition for novices. Cash is the most stable asset class, and alternative investments are frequently the most volatile, according to the investing risk ladder, which classifies asset classes based on their relative riskiness. Many novice investors frequently stick with index funds or exchange-traded funds (ETFs), when they begin their investment journey.
We have listed down the major asset classes below
- Cash In Bank
The simplest, clearest, and safest form of investment is a savings bank deposit. It guarantees that investors will receive their money back in addition to providing specific information about the interest they will earn. On the downside, interest on funds held in savings accounts rarely outpaces inflation. Although certificates of deposit (CDs) are less liquid than savings accounts, they often offer greater interest rates. However, there may be early withdrawal fees associated with CDs, and the money invested is locked up for a while (months to years).
- Bonds
An instrument traded on the stock exchange representing a loan from a lender to a borrower is called a bond. A typical bond will involve a business or a government organisation, and the borrower will give the lender a predetermined interest rate in return for using their money. In companies that utilise them to finance operations, purchases, or other projects, bonds are commonplace. Interest rates essentially dictate bond rates. As a result, they are actively traded when the Federal Reserve or other central banks raise interest rates or during periods of quantitative easing.
- Mutual Funds
A mutual fund is a kind of investment in which multiple investors combine their funds to buy securities. Mutual funds are managed by portfolio managers who divide and distribute the pooled investment across stocks, bonds, and other instruments, therefore they are not always passive investments. The majority of mutual funds need a minimum commitment of INR 500. One can have exposure to up to 100 different equities in the portfolio of a given fund with even a very small investment. Mutual funds can occasionally be created to mirror the performance of underlying indices like Nifty 50 or Sensex. There are a lot of mutual funds that are actively managed, which means that their allocations within the fund are carefully monitored and changed by portfolio managers. However, these funds typically have higher expenses that might reduce an investor’s returns, such as annual management fees and front-end charges. At the conclusion of the trading day, mutual funds are evaluated. All buy and sell transactions are also completed after the market has closed. Instead than concentrating on a small number of companies, many financial experts encourage their customers to diversify into a wide range of securities.
- Exchange Traded Funds (ETFs)
Exchange-traded funds (ETFs) were first introduced in the middle of the 1990s and have since grown fairly popular. ETFs are a sub-category of mutual funds, however, they are listed on the stock exchange and are traded on the stock exchange in a fashion similar to stocks. They mimic the buying and selling patterns of stocks in this way. This also implies that their value is subject to significant fluctuations throughout a trading day. ETFs can follow any other stock-based index that the ETF issuer wants to replicate, such as the Nifty 50 or Sensex. This can cover a wide range of topics, including commodities, emerging markets, niche industries like biotechnology or agriculture, and more. ETFs are very well-liked by investors due to their simplicity in trading and extensive coverage.
- Stocks
Stocks allow investors to benefit from dividends and price rises that result from a company’s success. Shareholders do not own the firm’s assets, but they do have a claim to them in the case of liquidation, or the company going bankrupt. Common stock owners have the ability to vote at shareholder meetings. Preferred stock investors are given preference over common stockholders in dividend payments but do not have voting rights.
- Alternative Investments
The world of alternative investments is large and includes the following kind of investments: P2P lending, cryptocurrencies, NFT, etc.
- Real estate
Investors might purchase commercial or residential properties outright to obtain real estate. Alternatively, they could participate in real estate investment trusts by purchasing shares (REITs). Similar to mutual funds, REITs allow a number of investors to pool their assets to buy real estate. On the stock exchange, they are traded like stocks.
- Hedge funds
Hedge funds can invest in a variety of “alpha-producing” assets that aim to outperform the market. Performance is not assured, though, and hedge funds may underperform the market by a wide margin due to dramatic swings in return patterns. These vehicles frequently demand significant initial investments of INR 1 crore or more and are ordinarily only accessible to certified investors. They frequently impose requirements for net wealth as well. An investor’s funds may be held hostage for extended periods of time if they invest in hedge funds.
- Private equity Funds
Like mutual and hedge funds, private equity funds are pooled investment vehicles. The “adviser,” a private equity company, pools the money contributed to the fund by various investors and then makes investments on the fund’s behalf. In an effort to increase the value of a functioning firm, private equity funds frequently acquire a controlling stake in it and actively manage it. Other private equity fund tactics include focusing on startups or rapidly expanding businesses. Private equity funds, typically concentrate on long-term investment prospects of 10 years or more.
- Commodities
Agricultural products and tangible resources like gold, silver, and crude oil are referred to as commodities. Commodity investments can be accessed in several different ways. A popular way is investing in futures and options of commodities which are listed on commodity exchanges like the Multi Commodity Exchange in India (MCX). Another popular way is to invest in ETFs which are investing in commodities, presently the Securities and Exchange Board of India has permitted ETFs in two commodities which are gold and silver.
Portfolio Construction – How To Build
Using the asset classes mentioned above, many seasoned investors diversify their portfolios, with the asset allocation matching their risk appetite. Start with small investments, then gradually build your portfolio, is sound advice for investors. Before going on to individual stocks, real estate, and other alternative assets, mutual funds or ETFs are a smart place to start. The majority of people, however, are too preoccupied to be concerned about daily portfolio management. So sticking with index funds is also an extremely popular investment option.
Conclusion
Both investing in education and avoiding assets you don’t completely comprehend are crucial. Rely on sensible advice from seasoned investors and ignore “hot suggestions” from dubious sources. Above all, spread out your investments among a variety of assets.
FAQ
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What Kinds of Asset Classes Are There?
Stocks, bonds, and money market instruments have traditionally been regarded as the three main asset classes. Many investors today would view commodities, futures, derivatives, real estate, and even cryptocurrency as independent asset classes.
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Which are the least liquid asset classes?
Land and real estate are typically regarded as among of the least liquid assets due to the lengthy process involved in purchasing or selling a property at market value. The easiest to sell for their full value, money market instruments are the most liquid.
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Which asset classes do well when inflation is high?
Because of their propensity to appreciate in value when prices rise, commodities and real estate are seen as effective inflation hedges. Some government bonds are also inflation-indexed, which makes them a desirable option for storing extra money.
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