Investment management, also referred to as portfolio management, is a complex process or activity that may be divided into seven broad phases: (1) specification of investment objectives and constraints, (2) choice of asset mix, (3) formulation of portfolio strategy, (4) selection of securities, (5) portfolio execution, (6) portfolio revision and (7) portfolio evaluation.
Investment objectives are expressed in terms of return and risk. As an investor you would primarily be interested in a higher return (in the form of income and/or capital appreciation) and a lower level of risk. Since risk and return go hand in hand, you should state your preference for return relative to your distaste for risk.
In your scheme of investments, you should accord top priority to a residential house and a suitable insurance cover. In addition, you must maintain a comfortable liquid balance. Once these are taken care of, your asset mix decision is concerned mainly with financial assets which may be divided into two broad categories viz., stock and bonds.
The conventional wisdom on stock bond mix is reflected in two propositions: (1) Other things being equal, an investor with greater tolerance for risk should tilt the portfolio in favor of stocks, whereas an investor with lesser tolerance for risk should tilt the portfolio in favor of bonds (2) Other things being equal, an investor with a longer investment horizon should tilt his portfolio in favor of stocks whereas an investor with a shorter investment horizon should tilt hid portfolio in favor of bonds.
The second proposition is based on the benefit derived from ‘time diversification’ which is distinct from ‘portfolio diversification’. Paul Samuelson and others have argued that the notion of time diversification is fallacious because even though the uncertainty about the average rate of return diminishes over a longer time period, it also compounds over a longer time period.
Although the above critique of time diversification is mathematically correct all is not lost for those who believe in the principle of time diversification. There remain some valid reasons why you should still condition your risk exposure on your investment horizon.
Two broad choices are available with respect to portfolio strategy, viz., an active strategy or a passive strategy. An active strategy is followed by most investment professionals and aggressive investors who strive to earn superior returns, after adjustment for risk. The four principal vectors of an active strategy are: market timing, sector rotation, security selection, and use of a specialized concept.
Market timing involves departing from the normal or strategic or long run asset mix to reflect one’s assessment of the prospects of various assets in the near future.
The concept of sector rotation can be applied to stocks as well as bonds. When applied to stocks, it involves shifting the weightings of various industrial sectors based on their assessed outlooks. With respect to bonds, sector rotation implies a shift in the composition of the bond portfolio in terms of quality (as reflected in credit ratings), coupon rate, maturity, and so on.
Security selection involves a search for under priced securities. If you resort to active stock selection, you may employ fundamental and/or technical analysis to identify stocks which seem to promise superior returns. As far as bonds are concerned, security selection calls for choosing bonds which offer the highest yield to maturity at a given level of risk.
Another approach to achieve superior returns is to employ a specialized concept like growth stocks, out of favor stocks asset rich stocks, technology stocks and cyclical stocks.