16.2 Portfolio Management Process

Explore the detailed processes in portfolio management, including defining investment objectives, designing investment policies, asset mix development, security selection, and periodic re-evaluations.

The Portfolio Management Process

Although securities are sometimes selected on their own merits, portfolio management emphasizes the dynamics of securities within a broader context. This process is known as the portfolio approach. It considers the inter-relationships between various securities and their collective impact on the overall portfolio.

Key Concepts

  • Return: The return of the portfolio is the weighted average of the returns of each security within it.
  • Risk: The risk of a portfolio is generally lower than the risk of individual securities due to diversification.

The idea is that the interaction among securities results in a portfolio that has a superior risk-reward profile than its components considered independently. This is a fundamental advantage of the portfolio management approach.

Steps in Portfolio Management

The following are the fundamental steps in the portfolio management process:

  1. Determine Investment Objectives and Constraints: Identify the goals and limitations pertinent to the investor, such as income requirements, time horizon, and risk tolerance.

  2. Design an Investment Policy Statement (IPS): Document the client’s objectives, constraints, and the strategies to be employed in a formal IPS.

  3. Develop the Asset Mix: Allocate assets among various asset classes (e.g., equities, bonds, cash) to achieve the desired balance of return and risk.

  4. Select Securities: Choose specific securities to include in the portfolio based on analysis and valuation.

  5. Monitor the Client, the Market, and the Economy: Continuously review the client’s situation, market trends, and economic conditions.

  6. Evaluate Portfolio Performance: Assess the performance of the portfolio relative to the objectives and benchmarks.

  7. Rebalance the Portfolio: Adjust the portfolio as necessary to realign with the prescribed investment strategy.

This process is iterative, as illustrated in Figure 16.1, with regular re-evaluations of investment objectives and constraints essential to align with evolving client needs.

Portfolio Management Cycle

    graph TD
	    A[Determine Investment Objectives and Constraints] --> B[Design an Investment Policy Statement]
	    B --> C[Develop the Asset Mix]
	    C --> D[Select Securities]
	    D --> E[Monitor Client, Market, and Economy]
	    E --> F[Evaluate Portfolio Performance]
	    F --> G[Rebalance the Portfolio]
	    G --> A

Frequently Asked Questions (FAQs)

Q1: Why is diversification important in portfolio management?

A: Diversification helps lower the overall risk of a portfolio by spreading investments across various asset classes and securities, reducing the impact of any single investment’s poor performance.

Q2: What is an Investment Policy Statement (IPS)?

A: An IPS is a formal document outlining an investor’s goals, constraints, and strategies to be followed for achieving these goals. It serves as a guideline for investment decisions.

Q3: How often should a portfolio be rebalanced?

A: The frequency of rebalancing depends on the investor’s objectives and market conditions. Typically, portfolios are rebalanced annually or semi-annually.

Mathematical Formulas

Portfolio Return

$$ R_p = \sum_{i=1}^n w_i R_i $$
  • (R_p): Portfolio return
  • (n): Number of securities
  • (w_i): Weight of each security
  • (R_i): Return of each security

Portfolio Risk

The risk of a portfolio ((\sigma_p)) can be seen as:

$$ \sigma_p^2 = \sum_{i=1}^n \sum_{j=1}^n w_i w_j \sigma_i \sigma_j \rho_{ij} $$
  • (\sigma_p^2): Variance of the portfolio
  • (w_i), (w_j): Weights of securities
  • (\sigma_i), (\sigma_j): Standard deviations of securities
  • (\rho_{ij}): Correlation between securities

Key Takeaways

  • Risk and Return: The portfolio approach generally aims to optimize risk and return by considering how different securities interact rather than focusing on individual performance.
  • Continuous Process: Portfolio management is an ongoing cycle that requires periodic reassessment to align with changing financial goals and market conditions.
  • Structure and Discipline: An Investment Policy Statement (IPS) provides a structured approach that aids in maintaining discipline in portfolio management.


  • Diversification: Strategy of spreading investments across various financial instruments to reduce risk.
  • Investment Policy Statement (IPS): A formal document outlining an investor’s objectives, limitations, and strategies.
  • Asset Mix: Distribution of investments across different asset classes.
  • Rebalancing: Adjusting the portfolio to align with the desired asset allocation strategy.

By following these structured steps and maintaining disciplined oversight, financial professionals can better manage clients’ portfolios to meet their evolving investment goals.

📚✨ Quiz Time! ✨📚

🧐 Assess and Solidify Your Understanding

Welcome to the Knowledge Checkpoint! You’ll find 10 carefully curated quizzes designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you’re on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

Good luck! 🍀💪

## What is the primary focus of portfolio management? - [ ] Selection of securities based solely on their individual merits - [x] Selection of securities based on their interaction and contribution within the portfolio - [ ] Prioritizing high-risk, high-reward securities - [ ] Eliminating risk entirely from the portfolio > **Explanation:** Portfolio management emphasizes the selection of securities based on how they interact with each other and contribute to the overall portfolio, rather than their individual merits alone. ## What is the core benefit of the portfolio approach in portfolio management? - [ ] Higher returns with higher risk - [ ] Consistently higher individual security performance - [ ] No need for continuous monitoring - [x] Improved risk-reward trade-off > **Explanation:** The portfolio approach provides an improved risk-reward trade-off, as the combined effect of securities within a portfolio tends to reduce overall risk. ## What comprises the return of a portfolio? - [ ] Sum of the returns of each security - [ ] Median return of all securities - [x] Weighted average of the returns of each security - [ ] Maximum return of the top security > **Explanation:** The return of a portfolio is the weighted average of the returns of each security within it. ## Which step in the portfolio management process involves establishing an investment policy statement (IPS)? - [ ] Determine investment objectives and constraints - [ ] Monitor the client, the market, and the economy - [ x] Design an investment policy statement - [ ] Select securities > **Explanation:** Designing an Investment Policy Statement (IPS) is the second step in the portfolio management process. ## How often should the portfolio management process be revisited? - [ ] Once a year - [ ] Once every five years - [x] Periodically, as clients' investment objectives and constraints change - [ ] Only when there is a significant change in market conditions > **Explanation:** The portfolio management process is a continuous cycle that must be revisited periodically as clients' investment objectives and constraints can change over time. ## What is the role of evaluating portfolio performance in the portfolio management process? - [ ] To monitor economic conditions - [ ] To rebalance the portfolio - [x] To assess whether the portfolio is meeting its objectives - [ ] To determine the initial asset mix > **Explanation:** Evaluating portfolio performance aims to assess whether the portfolio is meeting its set objectives. ## Which of the following best describes rebalancing a portfolio? - [ ] Creating an initial investment policy statement - [ ] Identifying high-yield securities for the first time - [x] Adjusting the mix of securities to maintain desired risk and return levels - [ ] Ceasing all transactions on the portfolio > **Explanation:** Rebalancing involves adjusting the mix of securities in the portfolio to maintain the desired risk and return levels. ## What does developing the asset mix involve in the portfolio management process? - [ ] Selecting individual securities without a strategy - [x] Determining the proportion of various asset classes - [ ] Implementing high-frequency trading strategies - [ ] Monitoring clients and market conditions > **Explanation:** Developing the asset mix involves determining the proportion of various asset classes such as stocks, bonds, and other investments within the portfolio. ## Which of the following steps comes directly after designing an investment policy statement in the portfolio management process? - [ ] Monitor the client, the market, and the economy - [ ] Evaluate portfolio performance - [ ] Rebalance the portfolio - [x] Develop the asset mix > **Explanation:** After designing an investment policy statement, the next step in the portfolio management process is to develop the asset mix. ## In what way is monitoring clients, markets, and the economy crucial to portfolio management? - [ ] It ensures that all investments are equally weighted - [x] It helps in making adjustments based on changes in client objectives and market conditions - [ ] It reduces the need for rebalancing - [ ] It eliminates the need for an investment policy statement > **Explanation:** Monitoring clients, markets, and the economy is crucial because it helps in making necessary adjustments based on changes in the clients' investment objectives and the prevailing market conditions.

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Saturday, July 13, 2024