I am going to start the blog with the basics of portfolio management. We will expand on this in upcoming blogs. Risk drives return in a portfolio and this is the reason one needs to focus on managing risk to be able to better manage returns. In this article, we will talk about risk as it relates to asset allocation.
Asset allocation is how we distribute our wealth among different asset classes. An asset class is nothing but a collection of assets with similar characteristics. For example, shares of companies that trade on exchanges are part of the broad equity asset class. This class can be divided into sub-classes such as domestic, international, large cap, small cap, REITs, etc. Similarly the fixed income asset class comprises Treasury bonds, corporate bonds, municipal bonds, high yield bonds, etc. And finally, cash and cash equivalents such as money market funds comprise the cash asset class. There are some other complex asset classes such as derivatives and alternative investments such as private equity and hedge funds, which we will address in upcoming articles.
I am going to break the portfolio management process into four steps.
Investment Policy Statement
The first step involves constructing an investment policy statement. It helps guide our goals, milestones, and constraints. It offers us an overview of the types of risks we are willing to take and our ability to take those risks. Our investment decisions need to be driven by this statement and we need to periodically review this statement because our needs, goals, and risk profile change with age and change in personal circumstances. Here’s a link to our article on investment policy statement.
The second step is examining past, and current trends in the financial, economic, and geopolitical and social environment and making projections about the future. These factors are dynamic so our investment decisions will have to be constantly monitored and updated to reflect market expectations.
The third step is the actual portfolio construction. We will determine how to allocate our funds across different asset classes in a way that we meets the needs in our policy statement while minimizing risks.
The fourth step is the continual monitoring of the market conditions, evaluation of the policy statement and make changes when necessary.
We will discuss each of these topics in depth in the next few articles. Until then, Happy Investing!