A passive portfolio strategy calls for creating a well diversified portfolio at a pre-determined level of risk and holding it relatively unchanged over time, unless it becomes inadequately diversified or inconsistent with the investor’s risk return preferences.
The factors that are commonly considered in selecting fixed income avenues are: yield to maturity, risk of default, tax shield and liquidity.
Three broad approaches are employed for the selection of equity shares: technical analysis fundamental analysis, and random selection.
Security transactions tend to differ from normal business transactions in two fundamental ways: (1) A businessman entering into a transaction does so with reasonable understanding of the motives of the party on the other side of the transaction. In contrast, in a typical securities transaction, the motive, and even the identity, of the other party is not known. (2) While both parties generally gain from a business transaction, a securities transaction tends to be a zero sum game.
Portfolio 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.
Why do people trade? One motivation is cognitive. People trade because they think they have superior information or better methods of analyzing information. Another motivation is emotional. Trading can be a source of pride.
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.
The securities market appears to be thronged by four types of players or transactions: Value based transactors (VBTs), information based transactors (IBTs), liquidity based transactors (LBTs) and pseudo information based transactors (PIBTs). Generally, the dealer or the market maker intermediates between these transactors.
Who wins and loses in the trading game which is essentially a zero sum game? It appears that the IBT’s odds of winning are the highest, assuming that his information is substantial by the market. He is followed by the VBT, LBT, and PIBT in that order.
The following guidelines must be borne in mind while executing transactions. (1) Maintain a dialogue with the broker. (2) Place an order which serves your interest best (3) Avoid serious trading errors.
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.
While portfolio rebalancing involves shifting from stocks to bonds or vice versa, portfolio upgrading calls for re-assessing the risk return characteristics of various securities, selling over priced securities, and buying under priced securities.
The key dimensions of portfolio performance evaluations are rate of return and risk.
To calculate the average rate of return of a portfolio over a period of several years, the following measures may be employed: (1) arithmetic average, (2) internal rate of return, and (3) geometric average.
The risk of a portfolio can be measured in various ways. The two most commonly used measures are standard deviation and beta.
The three popularly employed portfolio performance measures are: Treynor measure, Sharpe measure, and Jensen measure. They are defined as follows:
Treynor measure: Excess return on portfolio p / Beta of portfolio p
Sharpe measure: Excess return on portfolio p / Standard deviation of return of portfolio p
Average return on portfolio p – Risk return + Portfolio beta (Average return on market portfolio – Risk free return)
Performance measurement is basically a good idea. In practice however, it is often not applied properly.