What is Portfolio Management? 5 Things Investors Should Know

|

What comes to mind when you hear the term “portfolio management”? Depending on where you are in your life and career, you may only be familiar with the basics, or you may have a fairly well-rounded understanding of how investment portfolios work and why they’re so important. 

Regardless of where you stand—whether you’re a beginner investor looking to expand your knowledge or an experienced investor looking for a quick refresher—we’ve got you covered.

What is portfolio management and why is it important? 

According to personal finance website The Balance, “Portfolio management is about managing your family's investment holdings in a way that's consistent with your liquidity needs, risk profile, goals, and objectives.”

If you want to be successful as an investor—and who doesn’t?—maintaining a well-balanced investment portfolio is crucial to achieving your goals. The raison d’etre of portfolio management is to ensure that your investments are performing as expected, i.e., that you’re maximizing your returns and minimizing your risk. 

What types of investments are available?

Investments fall into three main categories: stocks, bonds, and cash equivalents. Here’s the basic breakdown: 

Stocks. A stock is an investment in a particular company. When you purchase a stock, you’re purchasing a very small share of that company’s assets and earnings. 

Bonds. A bond is a type of investment that allows you to loan money to a company or government entity, and in exchange the bond issuer pays you back, with interest. Bonds are generally considered safer than stocks because they provide a steady flow of income (as long as the bond issuer doesn’t default). 

Cash equivalents. Cash equivalents are short-term, highly liquid assets that typically mature within 90 days. They can include savings accounts, money market accounts, treasury bills, certificates of deposit, bankers’ acceptances, commercial paper, and other marketable securities. 

You can invest in any of these options directly, by choosing your own, or indirectly, via a mutual fund

Mutual funds. Mutual funds are investment funds that pool your money together with other investors to purchase shares of a collection of stocks, bonds, or other securities. 

Mutual funds are professionally managed, which means they’re a great option if you don’t want to spend time researching and managing your own portfolio of individual stocks. Many experts recommend that investors use mutual funds to form the bulk of their portfolios since they offer convenience, diversification, and, typically, lower trade costs. 

Mutual funds can be actively or passively managed. Actively managed funds have a manager or management team that makes all the investment decisions. They seek to outperform the market, which means they carry the potential to provide big returns—but also pose a greater risk—to investors. 

Passively managed funds simply follow a market index and therefore carry less risk. 

These days, investment experts believe that passively managed funds deliver greater returns over time. Index funds and exchange-traded funds are two types of mutual funds that are passively managed. 

Index funds. Index funds are constructed to track the components of a particular market index, such as Standard & Poor’s 500 Index or the Nasdaq. Index funds are generally considered to be ideal core portfolio holdings for retirement accounts, e.g., individual retirement accounts (IRAs) and 401(k) accounts.

Exchange-traded funds. Exchange-traded funds, or ETFs, are funds that can be traded like individual stocks. They differ from index funds in that their pricing takes place throughout the trading day, whereas pricing on index funds only occur at the end of the day. They also tend to charge lower fees than traditional mutual funds. 

What factors should I consider when assembling my portfolio?

In addition to knowing the types of investments that are available and the defining characteristics of each, you should also have a basic understanding of asset allocation, diversification, and rebalancing if you wish to maintain a healthy portfolio. 

Asset allocation. Asset allocation is an investment strategy wherein you divide your investment portfolio among the different asset categories—stocks, bonds, and cash. 

The goal of asset allocation is to arrive at a mix of assets that maximizes returns and minimizes risk. However, your personal asset allocations will depend on your “appetite for risk.” If you want to invest aggressively, you may choose to invest more in volatile stocks. If you want to invest conservatively, you’ll likely want to weigh your portfolio toward more stable investments. 

Diversification. Diversification involves the spreading of risk and reward between and within asset categories. “The thinking is that if one sector or one holding goes down, the whole portfolio won’t sink and may even experience gains elsewhere,” says Javier Simon, an investing expert for SmartAsset. “Experts often recommend diversification for long-term investments such as retirement accounts.”

Rebalancing. When you rebalance your portfolio, you buy and sell certain stocks, funds, and other securities in an effort to bring your portfolio back to your original asset allocation mix. To maintain a well-managed portfolio, avoid “portfolio drift,” and reduce your exposure to risk, rebalancing should be done periodically (typically once or twice a year.)

How do I customize my portfolio to suit my particular financial needs? 

When customizing your portfolio, it’s important to consider your age (or time horizon) and your tolerance for risk. Many investors choose to invest more aggressively when they’re younger and still have decades to recover from market volatility and temporary declines in stock prices, then more conservatively when they’re nearing retirement in order to be less exposed to risk. 

The traditional wisdom about determining asset allocation by age used to be that you should subtract your age from 100, and then use that number to determine the percentage of your portfolio that should be kept in stocks, which are more volatile. In recent years, that number has been bumped up to 110 due to the fact that retirees are living longer. However, many experts now believe this approach is too simplistic, and that other asset allocation strategies often lead to better outcomes. 

Ultimately, your best bet is to weigh your age, income, and financial goals against your particular tolerance for risk. Many investment companies are now offering model portfolios to help you make informed choices. 

What else should I know about portfolio management? 

Here are a few additional pieces of advice that most investment experts agree on: 

  • Don’t buy stocks based on rumors. Research every investment and make choices based on that research rather than whispers about what a stock is “about to do.”
  • Don’t try to time the market. It simply never works
  • Don’t let your emotions guide your investment choices. “Fear and anger can quickly lead to irrational thoughts or actions. In these situations, the “fight or flight” response convinces us we have to move quickly, based on our instincts,” says U.S. News & World Report contributor Scott Holsopple. A scared or angry investor might place trades too often, causing them to get hit with extra fees as a consequence, or move their funds into cash when the market drops, thus locking in their losses.”
  • Do pay attention to fees. Make sure to research the costs of your investments before diving in to avoid getting hit with trade commissions, expense ratios, and advisor fees, all of which can diminish your earnings. 
  • Do seek out people and resources that can help you succeed. You don’t have to go it alone if you need help or have questions. Any financial advisor who’s well-versed in investing should be able to offer you advice if you have questions about your investment strategy. 

You can also use portfolio management software that automates many of the more time-consuming aspects of investing. The right software can help you track your progress, run analyses on your asset allocations, compare your portfolio performance to market benchmarks, and much more.

The Bottom Line on Portfolio Management

Effectively managing a portfolio over the course of a lifetime takes patience, foresight, and dedication. But if you focus on asset allocation and diversification, avoid panicking when the market experiences its natural ups and downs, and stay the course with your long-term strategy, you’ll be well-positioned to benefit from your investments throughout the course of your lifetime.