Developing New Techniques in Portfolio Management - Essay Example

Developing new Techniques in Portfolio Management Number June 23, Faculty Developing new Techniques in Portfolio Management Introduction Whether the index return is sufficient to finance future wealth accumulation and consumption goals of an investor or if the risk involved aligns with his or her risk tolerance is a concept that many investors do not understand. More often, money managers take risks that are greater than the index due to the inability to interpret their personal goals prudently in terms of risk and return. The speculative objective of beating the market that many money managers adopt partially aligns with the long-term goals of the investors (Brentani, 2014). We ought to understand that decision-making in the field of investment is quite complex and requires prudence. The risks and return of a portfolio, as required by prudent investment, should match the concrete objectives of the investor as opposed to the abstract goals of beating the market. A portfolio must generate sufficient returns that support the legitimate expectations and needs of the investor. The portfolio should be synchronized to the aspirations of the investor rather than being designed to outdo a peer group to achieve these objectives. The management of a portfolio has proved a difficult task where traditional techniques that lack a practical dimension are adopted. Prudent investment strategies should be designed to generate optimal returns and enhance the successful attainment of distinct critical goals. However, an overemphasis on the methods that can maximize profits is not a prudent way to approach investment decisions. Instead, investors are now shifting to the determination of risks and returns that are required to secure a promising economic future in their investment decisions (Fabozzi & Markowitz, 2011). To design portfolios that meet the consumption and savings goals of the investor, techniques that strike a balance between the constraints and preferences imposed by risk tolerance and personal circumstances of the investor are necessary. The discussion that follows critically explores the most prudent techniques of portfolio design and management that go beyond the traditional treasure hunting techniques. Prudent Investment Decision-Making and Selection of Portfolios A wise investment decision should begin by identifying the returns that can generate sufficient money to meet the cash flow liabilities that must be discharged by the portfolio or wealth accumulation goals. Despite the fact that returns above the risk-free rate can be interpreted to mean that the investor takes the risk, the risks associated with investment must be commensurate with the performance objectives. Both the risk and return should be consistent and measurable with the risk tolerance and needs of the investor (Lederman & Klein, 2008). A prudent investment decision is that which evaluates the originality of the portfolio both in comparative terms and its progress towards the objectives. It is important to notice that there may not be an absolutely ‘right’ or ‘wrong’ decision. One course or another could be appropriate and worth pursuing depending on the context of the decision. What makes one investment alternative more suitable than another is the risk and return involved and how effectively such alternative meets the desired objectives. A careful consideration of the investment plan should form the foundation of the return generating process. Where care is not exercised, the generation of returns depends on luck. The nature and scope of the investment are necessary for the formulation of investment policy. It is the policy that stipulates the steps that should be adopted when planning the assets that are feasible investments and whether the investor should combine the assets under a portfolio. Such asset allocation policy should determine the required portfolio return that meets the investment objectives and the portfolio risk involved. A distinction between the desired and the required return while at the same time taking into consideration the chances that the expected return may not be attained. A portfolio tax management policy is necessary for ascertaining whether or not the collection would require tax payments (Lederman & Klein, 2008). Investors should also understand whether the portfolio requires periodic adjustments to retain its strategic asset allocation and whether any regular distributions will accrue from the portfolio. Investors merely evaluate the effects of their portfolio distribution policies and, as a result, end up jeopardizing their investment capital and consequently causing the failure of the portfolio. The monitoring and evaluation of a portfolio, as it evolves through ages, is essential for forecasting the investment results and making the necessary adjustments. Modern Techniques for Building a Successful Portfolio A portfolios foundation is made up of the asset allocation decisions. Establishing a successful portfolio depends on how effectively the investor makes the asset allocation decisions. An appropriate diversification makes it possible for the investor to measure and control the overall portfolio risk (Rad & Levin, 2015). It all starts from the extent to which the investor is prepared to take the risk. A structure of the portfolio asset allocation stems from the speculation of the investor’s willingness to take portfolio risk based on the assumption that the investor intends to make a diversified portfolio. The investor’s risk tolerance and their required return determine the function of strategic asset allocation. In building a successful investment portfolio, the allocation of assets, where the expected return is lower than the return required to achieve the financial goals, should be considered inappropriate. Many investors severally make such a mistake. However, asset allocations that are bound to produce more risk than may be necessary considering the economic conditions and purpose of the portfolio are equally insidious. Therefore, a policy that allocates assets in a portfolio should be tailored to meet the return objectives of the investor and avoid the generation of a potentially harmful risk gap. A ‘risk gap’ arises where the investor voluntarily chooses to assume a risk that is greater than necessary. We all agree that more money is preferably better than a little money. However, the goal of pursuing more money conflicts with that of wealth accumulation in the context of building a successful portfolio. An effective and efficient portfolio management will require both the measurement and management of risk. Investors should track the behavior of a series of model portfolios to identify suitably an asset allocation that best align to their risk tolerance. As of such, the investors should consider the historical returns that accrue from the distinctly diversified portfolios all of which differ in the percentage of fixed income (bonds) and equities (stocks) to asset allocation. Investors should realize that owning a larger percentage of the fixed income investments (bonds) constitutes a low variance portfolio (Rad & Levin, 2015). A high variance portfolio, on the other hand, allocates more assets to stocks than to the bonds. Based on this concept, investors can easily evaluate the impact of different asset allocation selections depending on the return-risk choices of the individual investors. A successful portfolio is that which generates returns that are both above and over the prevailing cost of living. Investors should adjust their nominal annual portfolio returns for inflation to get an appropriate picture of the collection results. Owing to the constant Dollar adjustment results, inflation has become a threat that is both persistent and subtle to the portfolios than the global and domestic financial market shocks. There are more chances that inflation will significantly strike the purely fixed income portfolio that appeals more to the risk-averse investors (Rad & Levin, 2015). Although fixed income portfolios may seem to be safe in the short term, they usually turn to be riskier in the long run. Measuring the portfolio returns of a 100% fixed income say over a five-year period will generate the highest number of real losses. The importance of globally diversified and prudently balanced portfolios over the poorly diversified portfolios cannot be undermined. It should neither be 100% equity nor 100% bond. The investors preference for the all-equity investment emanates from the desire to accumulate wealth quickly. Nonetheless, such requires extraordinary risk tolerance and great patience on the part of the investor given the return variance properties involved. Upon the determination of the return and risk characteristics of a portfolio, an investor can begin the building and implementation of a portfolio. The first technique in this process should involve the careful selection of asset classes (Rajagopal, 2013). Such classes could include the emerging markets, real estates, and international bonds. Diversifying into different classes can help enhance the portfolios future economic outcome. The owning of illiquid financial assets by an investor often increases the intricacy of the asset allocation decision. Commercial real estates and residential estates, annuities, limited partnership units, business interests that are closely held and long-term deposit certificates belong to this category. Determining suitable target weightings should follow the selection of asset classes. Under this technique, the investors should tailor their portfolios to fit the wealth accumulation, cash flow, and other objectives. Factor loading advantages of each portfolio should be considered with care and caution. The process of portfolio building should be done based on the premise risk can be productive only when it can generate a reasonable return and that risks that are too large may be unproductive. Challenges Involved in Investment Decision Making and Portfolio Selection Making a prudent investment decision and the choice of a portfolio is not an easy task. It involves challenges and difficulties that limit the chances of success where care, caution, and absolute prudence are not exercised. Such barriers to effective decision making and portfolio selection include the complexity involved in the process. All financial decisions require an informed insight into the intricate economic and mathematical relationships that few investors understand (Rajagopal, 2013). It becomes increasingly difficult to define personal objectives where this complexity is encountered. Investment decisions involve a lot of uncertainty and investors often lack the knowledge of future outcomes. The success of portfolio is, therefore, more attributable to chance, and many investments are derailed by such uncertain circumstances. It is normal that investors get confronted with conflicting investment alternatives and objectives. The choice of the most appropriate alternative is a unique difficulty that manifests in investment decisions. Less appropriate decisions may be selected at the expense of better alternatives. There are multiple perspectives that present themselves when investors are making investment decisions. Different views arise for similar sets of data and end up being assigned different meanings. Different investors can draw different conclusions based on the same round of data. Such analysis depends on the individual experiences and economic conditions of the investors (Rajagopal, 2013). For example, investors that started accumulating wealth after the Great Depression will maintain different perspectives from those who experienced it. Information overload has become a problem faced by investors over the ages. The economic, legal and financial information keeps deepening and makes it impossible for the investors to determine the set of data that may be most reliable. In the event of such dilemma, investors misinterpret the situations and make risky decisions that compromise the success of the portfolios. Modern Techniques of Portfolio Management An integrated and fully comprehensive portfolio management policy should consider asset allocation from the viewpoint of an individual investor. The investor’s tolerance for risk changes with personal wealth accumulation. For some investors, the ability to tolerate risk increases with the value of the portfolio (Rad & Levin, 2015). However, some investors become more conservative when the portfolio value increases to increase their chances of meeting their financial objectives. An integrated system of portfolio management should focus on two primary goals: i) Optimizing the investor’s utility through the creation of an asset mix that generates reasonable rewards and risks, and ii) Monitoring the changes in investor circumstances so as to keep the portfolio aligned with the distribution requirements, the purpose of the investor, and other financial circumstances. Proper portfolio management largely depends on the approach adopted in the allocation of the assets. There are three distinct modern strategies that can be used in asset allocation. The Tactical Asset Allocation technique is founded on the assumption that the investor has a fixed risk-averse character (Rad & Levin, 2015). As a result, this method maintains that changes in wealth do not affect allocation decisions. Changes in asset prices, however, influence the future capital market expectations. Market correlations, risks, and expected returns are all affected. Where this approach of asset allocation is used, market timing systems and strict contrarian techniques of managing the portfolio would be appropriate. The Strategic Asset Allocation method is based on the determined investors exposure to the systematic risk sources. The belief that capital markets will remain efficient over a long planning period plays a paramount role in this approach. To attain efficiency in the market, all known economic and financial information should be rapidly incorporated into the prevailing price of securities. A unanimous opinion about the value of the asset is reflected in the current price of the asset (Rad & Levin, 2015). The excess of the liquidity sellers over the information buyers and the reassessment of the propertys value constantly result in the price changes. Under this approach, the security prices represent what the market ought to explain. The setting of an appropriate asset allocation mix makes the portfolio remain fixed in the long-term. Constant mix and Buy-and-Hold portfolio management techniques are valuable under this approach. The Insured Asset Allocation strategy takes into account both the strategic and tactical approaches. Based on the efficient market perspective that there is a lack of predictability in price changes, the approach maintains that there is inadequate information to make market-beating systems that are profitable. Nevertheless, the approach is founded on a firm belief that changes in wealth influence the risk-averse character of the investor. The investors sensitivity to the investment risks is believed to increase with the falling portfolio value and decrease with increasing portfolio value (Rad & Levin, 2015). Assets can be shifted to risk-free treasuries where the value of the portfolio reaches the floor that is set under this approach. Where the value of the portfolio grows beyond the floor, more funds should be committed to equities. The Heuristic models, Scoring techniques, and the Mapping (Visual) techniques are all modern methods used to support the portfolio management process. Each of these techniques involves a complete spectrum of the portfolio management functions. Such methods include the prudent selection of investment projects and their successful execution through the creation of a formalized and project-friendly environment (Brentani, 2014). Heuristic models are initial approaches that can be used to optimize the financial returns on the portfolio. The use of these techniques, however, is deficient in the sense that it does not balance the portfolio by the strategy of the organization. The scoring techniques adopt a weighting criteria that considers such factors as risk, profitability, and strategic alignment and investment requirements of the portfolio. The over emphasis that scoring and heuristic techniques place over the financial measures of the collection make them unable to maximize on the project mix (Brentani, 2014). The mapping techniques can be used to visualize the balance of a portfolio through a two-dimensional graphical representation of several factors. The modern technique lays emphasis on the balance between risks and profitability, and the probability of success and financial returns. Examining Canadian Portfolio Management Practices Portfolio management and risk management practices in Canada are highly interrelated. The portfolio management practices are exercised under the Hedge Fund with each fund headed by a Hedge Fund Manager. The Hedge Funds are a type of a mutual fund from which investments are collectively done (Perry, 2011). Sound practices for the movement of cash, trading, pricing of portfolios and the maintenance of appropriate information systems are adopted in Canada. The processes involved in portfolio management depend on the complexity, size and strategy of the portfolio. A portfolio in Canada comprises different Hedge Funds that adopt different strategies to generate returns that are consistent with lower risk than any single fund. Under the system of investment diversification, a Fund of Funds is created.The optimal capacity of the fund depends on the assets rate of growth. An investment strategy depends on the financial instruments involved with a unique reference made to the buyers and sellers of such instruments in the market. Investing in a portfolio in Canada is a comparatively liquidity constrained process. Capacity limitations are set for individual Hedge Funds the attainment of which restricts further investments from the existing investors. Money investments from new investments cannot be accepted when the capacity limitations are attained. Minimum subscription amounts that are made monthly make the investments into the Hedge Fund. Redemptions from the portfolio are made either quarterly or monthly in a range of between ten and ninety days by individual investors (Perry, 2011). Lock-up periods and redemption penalties are used to regulate the redemptions. Portfolio management in this mutual fund involves a consideration that matches the Hedge Fund liquidity to that of the individual investors. The portfolio managers are constrained from redeeming from or allocating to the first preference in the course of managing the Fund. Investment constraints are dealt with through negotiated capacity reservations. Maximum and minimum strategy allocation bands are established, and all sell and buy decisions get implemented within the bands. Target asset allocations are amended alongside any changes in market conditions and procedures. The selection of portfolio and investment decisions from within the Hedge Fund is made based on the risks involved, and the returns anticipated. The choice of one strategy in the place of another is done based on its ability to adequately meet the collective objectives of the investors (Perry, 2011). Funds are invested in different securities on a 60/40 scale for the fixed income and equity securities respectively. Compared to the assertions of the portfolio management theory, the Hedge Fund adopts practices that reflect unanimity to the greater extent. However, the fund appears to foster more focus on the traditional treasure hunting techniques based on risk and return with little considerations for the accumulation of wealth and future economic state. Conclusions Effective portfolio management practices start from the careful selection of investment projects. Creating a successful portfolio and designing an appropriate portfolio management technique depend on both the risk and return involved. How well a collection meets the desired objectives and promises a stable economic future matters in portfolio management. Short term investment alternatives that purpose to generate wealth quickly are not preferable. Fixed income portfolios have their limitations as well. Proper portfolio management techniques maintain that either a purely equity or fixed income portfolio is undesirable. Instead, an appropriate asset mix that meets the objectives of the individual investor and aligns to the financial and economic measures is preferable. Modern portfolio management techniques such as mapping techniques should be preferred to traditional techniques such as heuristic and scoring models that cannot maximize on the project mix. Financial returns and the probability of success in a portfolio together with the risk involved and the profitability accruing from it are issues that require balance in sound portfolio management. References Brentani, C. (2014). Portfolio management in practice. Oxford [England]: Burlington, MA. Fabozzi, F., & Markowitz, H. (2011). The theory and practice of investment management. Hoboken, N.J.: John Wiley & Sons. Lederman, J., & Klein, R. (2008). Global asset allocation. New York: Wiley. Perry, M. (2011). Business-driven project portfolio management. Ft. Lauderdale, Fla.: J. Ross Pub. Rad, P., & Levin, G. (2015). Project portfolio management tools and techniques. New York: IIL Pub. Rajagopal, S. (2013). Portfolio management. Houndmills, Basingstoke, Hampshire: Palgrave Macmillan. Read More