Portfolio Revision

Irrespective of how well you have constructed your portfolio, it soon tends to become inefficient and hence needs to be monitored and revised periodically. Portfolios do not manage themselves nor can weather the ages unaltered. With each passing day, portfolios that we carefully crafted yesterday become very less than optimal. Change is the investor’s only constant.

Over time several things are likely to happen. The asset allocation in the portfolio may have drifted away from its target; the risk and return characteristics of various securities may have altered; finally the objectives and preferences of the investor may have changed.

Given the dynamic developments in the capital market and changes in your circumstances, you have to periodically monitor and revise your portfolio. This usually entails two things, viz., portfolio rebalancing and portfolio upgrading.

Portfolio Rebalancing:

Portfolio rebalancing involves reviewing and revising the portfolio composition (i.e. the stock bond mix). There are three basic policies with respect to portfolio rebalancing: buy and hold policy, constant mix policy, and portfolio insurance policy.

Under the buy and hold policy, the initial portfolio is left undisturbed. It is essentially a buy and hold policy. Irrespective of what happens to relative values, no rebalancing is done. For example, if the initial portfolio has a stock bond mix of 50:50 and after six months the stock bond mix happens to be, say, 70:50 because the stock component has appreciated and the bond component has stagnated, the portfolio mix is allowed to drift. Put differently, no changes.

The constant mix policy calls for maintaining the proportions of stocks and bonds in line with their target value. For example, if the desired mix of stocks and bonds is say 50:50, the constant mix calls for rebalancing the portfolio when relative values of its components change, so that the target proportions are maintained.

The portfolio insurance policy calls for increasing the exposure to stocks when the portfolio appreciates in value and decreasing the exposure to stocks when the portfolio depreciates in value. The basic idea is to ensure that the portfolio value does not fall below a floor level.

Portfolio Upgrading:

While portfolio rebalancing involves shifting from stocks to bonds or voice versa, portfolio upgrading calls for re-assessing the risk return characteristics of various securities (stocks as well as bonds), selling over priced over priced securities, and buying under priced securities. It may also entail other changes the investor may consider necessary to enhance the performance of the portfolio.

You may hesitate to revise your portfolio or be too slow in doing so. You may not like to incur the costs of trading like commission costs, taxes, and adverse market impacts. These costs often look very obvious. However, remember that there are costs of non-trading which, though subtle, may be significant. Your portfolio may drift into an asset mix that may no longer be appropriate to your needs, you may hold over priced investments, offering inferior returns, you may forego opportunities of making promising investments. You should learn how to weight the opportunity cost of non- trading against the explicit costs of trading. In essence, portfolio revision calls for developing an appropriate response to the tension the ‘apparent’ cost of trading and the ‘subtle’ cost of inaction.

Performance Evaluation:

The key dimensions of portfolio performance evaluation are rate of return and risk. This article looks at the measures of rate of return, risk, and performance.

Rate of Return:

Dividend income + Terminal value – Initial value / Initial value

To illustrate the calculation of the rate of return, let us look at the following data:

1. Initial market value of the portfolio : Rs 100,000
2. Dividend and interest income received toward the end of the year
: Rs 10.000
3. Terminal market value of the portfolio : Rs 105,000

The rate of return on this portfolio is simply:

10,000 + (105,000 – 100,000) /100,000 = 0.15 or 15 percent.