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Steps in Planning the Portfolio

Discuss about the Developing A Balanced Investment Portfolio for a Fund Manager.

When it comes to constructing a portfolio, different investors target different portfolio and select the fund manager depending on their requirements and preference. Selection of fund manager is just the initial requirement for the portfolio construction. In the wider sense, building of portfolio is the procedure of selecting the investments, which are best suited as the client’s requirement of return with compared to risk tolerance level. Private and professional investors construct their portfolio in different ways. The easiest way to explain these strategies are top down test and bottom up test.

Bottom up test: This approach is normally used by the private individual investor and starts from selecting the fund and the fund manager as per their choice. Only after completing this, they go for planning the portfolio with considering the risk and return factor. In addition, the client’s behaviour, risk tolerance level and preference should be taken into consideration. The investors always prefers top-performing funds, which results into loss of money for them as they buy the top selling funds at a loss (Reddy et al. 2013)

Top-down test: Professional investor, on the other hand, starts the investment plan with investigating the available funds. They apply various steps after generating a framework to select what type of investments is required. Only after analysing these factors, they select other investments or individual funds. Planning the portfolio after considering the investment objectives and risk tolerance level assist in meeting the targets within the acceptable level of risk (Mazzola and Gerace 2015).


The top-down test normally goes along the following wide approaches:

  • Deciding about how to distribute money over various categories of investment
  • Select the type of investment where to invest
  • Choose on the stability among index passive fund and actively managed fund
  • Assessment of various fund manager and individual funds

Figure 1: Construction methods of portfolio

(Source: Han 2013)

Allocation of asset:

Asset is a thing of value, which includes stocks, bonds, cash, any other securities and physical things like car, house or inventories. One of the major factors of planning a portfolio is the allocation of assets. Allocation ensures that the portfolio has perfect mix of assets to suit the client’s situation, expectation of return and risk tolerance level. Before planning for the portfolio, the client’s attitude to risk must be evaluated. The fund manager can help the investor in determining their risk tolerance level. The planner must conduct a meeting with the client and decide about the allocation of asset that suits the client best with regard to his requirement (Speelman, Clark-Murphy and Gerrans 2013).

Allocation of Asset

Diversification is stated as the segregation of money of the client over the various investments to lessen or protect against the unexpected risk in any individual market or particular investment. Investment risk is the risk of difference between the expectation and actual return of the investor. In order to minimise the risk the planner must diversify his risk among the wide mix of assets. The market of investment shifts in various cycles and reflects the potency of economy, sentiment of investors and trends of industry. The assets also shift as per the external aspects. For example, during unfavourable economic periods, people do not wish to buy expensive items and the manufacturing companies face down fall in sales, however, the producers of essential items like food may not experience the same situation. Diversification of portfolio can assist in smoothing out the difficulties in the market. Therefore, returns from well performing assets facilitates in offsetting those, which are not performing well (Gibson 2013).

The perception of risk and return proposes that low level of risk will eventually lead to low level of return. The high level of risk will eventually fetch high level of return. However, no planner can guarantee about the proposition. It may happen that high-level risk involved investment may fetch big loss instead of profit.  The fund manager just helps to construct the best possible portfolio for the client with regard to his return expectation and risk tolerance level. Using the strategy for allocation of asset assists in minimising the risk as per the market conditions. However, there are instances when the experience fund managers also get their timing wrong. Using the strategy can assist in assuring that the portfolio is balanced (Han 2013).              

Figure 2: Relation between risk and return

(Source: Han 2013)

Correlation is a statistical calculation for the degree to which the shifting of various types of assets are correlated. For efficient allocation of assets, the fund manager often tends to combine the assets that are expected to perform well in various times. Generally, construction of portfolio starts with a blank paper and the collection of funds available for investment. However, in actual, most of the investor already has a segregation of asset before they start planning for investment. The fund manager assists in allocation of assets and then re-arranges the investment over time so that the client has best option to meet his expectations from investment (He, Grant and Fabre 2013). 

Diversification

Investments are categorised into various classes of assets like, bonds, equities, cash and properties. The table shown below pointed out the various types of assets, their main characteristics and for which they are potentially suitable (Brown and Tiu 2013).

Classes of assets

Main characteristics

Potential appropriateness

Bonds

Can offer a reliable and stable income with possibility of higher growth rate and interest rate; It involves oversees government bonds, corporate bonds and UK government bonds

Long, medium or short term investors

Equities

Useful for monitory growth and are able to generate income through dividend payments and can be invested in oversees companies and UK

Medium and Long-term investments, usually 5 years plus

Cash

Appropriate for short-term requirements such as future down payment on a new house. It generally includes term deposits and securities which pays higher rate of interest

Short-term investors usually for up to three years

Property

Offer the advantages of diversification through right to use the properties in office, retail, tourism, industrial and infrastructure segments. And can be invested  in UK as well as international assets

Medium and Long-term investments, usually 5 years plus

Table 1: Classification of assets

(Sources: Created by author)

Other potential securities are:

  • Australian fixed interest: The benefits of investing in a spread portfolio of that bears interest can offer regular income. The amount invested with fixed rate of interest and taken from the State Governments, Commonwealth, Banks and any other Australian Ethical Charter that meets the criteria of USB Index for Composite Bond. The risk level is low to medium and the required period is 3 years.
  • Oversees fixed interest: Overseas fixed interest aim to offer regular income and they are perfect for moderate capital growth over medium-term period. Standard risk level for overseas fixed interest are low and are intended to suit investors who are willing to take moderate levels of risk with a modest potential for capital appreciation (Calza, Monacelli and Stracca 2013).

There are no arguments that shares are a major part of any portfolio for the investors who want a balanced portfolio with regular return with accepted level of risk. The reason behind this is over time, shares are expected to pay higher level of return than the investment potion like cash and bonds. However, it will not be a wise idea to put all the money in the same area as it is said with relation to investment that “Don’t put all your eggs in the same basket”.

Before buying the preferable stock from the market, the investor must consider the types of portfolio he is preferred to buy. Speculative trading is only a small element of the strategy to investment, as long-term investment is a strategy that works best for most of the investor, most of the time. Rather than investing in any particular bond or share or asset, diversification of investment over various funds gives best result for most of the investor. Every investor has different preference, however, most of the investors look for a mixture of income and capital gain and a return that is more than the average market return. There are various strategies to construct an index-beating portfolio, but beating the index is not the only major concern. The investor must consider how much he wants to beat it by, and the risk tolerance level to target the objective.

Assuming the primary objective of the investor to hit the index, the planner needs to evaluate exactly what is his requirement. The major market indexes are the reasonable representative cross-section of various areas of activity in the Australian economy. To create the same return as the index, the investor has buy all 300 or 500 stocks from that index, and he should capture the index return before costs. If the S&P/ASX 300 earned 20% for the year, the portfolio would gain 20 per cent, before costs. If it fall, the portfolio will also fall. The fund managers set up quantitative methods for following the alterations in the components of the selected index as companies drop out, drop in, and simply copy the index portfolio. The best technique to hit the index is through the exact style of investing that suits private investors. For example, if the client has a fund of $5000, the value of setting up a investment of 10-stock would assure that the client will face problems earning a profit even if the market rises.

Balancing Between Return and Risk

Investors often want to know about how many securities they must have in their portfolios, and the most common answer for that is: "as many as you understand". For the new investors, the number is generally five to 10 securities.  On the contrary, for experienced investors the number may be less, in some instances it may be beneficial to put some money into a well-managed fund. Most of the part-time investors cannot control more than 12 portfolios. The investment criteria not only depend on the available time and knowledge of the investor but on the preference of expected return and risk tolerance level.  As the fund manager constructs the portfolio based on his experience, he may target for a final holding of around 5 to 10 securities and possibly not more than 15, even if he is an experienced investor. Adjusting with the number of stocks is a confront for most of the private investors. Holding this number of stocks offers the investor some opportunity for diversification of portfolio through company type, company size, industry and so on. Holding various shares with different features means the portfolio should not experience too bad impact if one does the planning poorly and is benefitted with good planning.

Assets

Allocation (%)

Range (%)

Australian Fixed interest

27

10 to 50

Overseas Fixed interest

8

0 to 15

Cash

5

0 to 15

Defensive Assets

40

30 to 50

Australian Equities

30

10 to 30

Property

15

0 to 20

Infrastructure

6

0 to 12

High yield fixed interest

4

0 to 8

Alternatives

5

0 to 10

Growth Assets

60

50 to 70

Table 2: Allocation of Assets

(Source: Created by Author)

The above table shows the maximum and minimum amount that can be invested in each class of assets and is shown under the heading “Range”. The allocation of asset can be varied from time to time. The variations must be within the range as shown above (Plumb, Kent and Bishop 2013).

The objective of the allocation as above is to invest in a wide category of assets, which have the capability of achieving the target over the long-term period. Probability of capital gains is there, however, chances of capital losses are also there. The strategy of investment included in the table are investment in a portfolio of fixed interest securities, overseas and Australian investment, listed property, cash and Australian equities. The risk measure for the above allocation is medium. The above portfolio is planned to suit the investors who are seeking moderate returns and willing to tale medium level of risk that is the requirement is of a balanced portfolio. The target time period is 5 to 6 years (Martinsuo and Killen 2014).

Assets

Allocation (%)

Amount ($ millions)

Australian Fixed interest

27

27

Overseas Fixed interest

8

8

Cash

5

5

Defensive Assets

40

40

Australian Equities

30

30

Property

15

15

Infrastructure

6

6

High yield fixed interest

4

4

Alternatives

5

5

Growth Assets

60

60

Table 3: Investment

(Source: Created by author)

The required return rate of the investor after expenses and taxes is 3% plus inflation. The present inflation rate as per CPI is 1.3%. Therefore the required rate of return is (1.3+3) = 4.3%.

From Equity: Return rate is 10%

From Fixed interest: Return rate is 5%

From Infrastructure and property: Return rate is 4%

Let the expenses and tax is 12%.

Therefore, the return is (10+5+4-12) = 7%, which is more than the required return of 4.3%

Four major levels of diversification, which can be summarised with the wide principles, are as follows:

For the total portfolio:

  • The investor must consider holding various types of investments and not only the shares.
  • The investor must consider investing part of his portfolio through managed funds to minimise the risk.

For the share portfolio:

  • The investor must hold more than the minimum number of shares in his portfolio, constructing up to 5 to 10 securities over time, and possibly 15 maximum for investors that are more skilled. Based on the energy and time that the client is willing to invest for the investment, if he chooses more than 10 stocks, then it will be problematic for him to keep track of all the investments. However, less than 5 will considerably increase the risk of big variations in value.
  • The investor must hold securities in various sectors, so that his portfolio is revealed to expansion in various areas of the economy and is less susceptible to a downfall in any particular industry.
  • The investor must seek various "categories" of available shares and should diversify his portfolio across the industries; the investor can get returns without taking too much risk if he includes speculative stocks and blue-chip to his portfolio.
  • The investor must look for companies with various features. The investor can meet all types of successful companies – right from the fast-growing companies to slow-growing companies or to rotating companies that may be bouncing back from the crucial positions or the companies that somehow managing to develop.
  • The investor must choose the stocks that will fulfil his requirement. It is crucial to construct a portfolio that suits the investor’s approach of investing. If the investor is required to earn a regular income, he will have to search for at least two or three securities that will fulfil his purpose.

Therefore, with considering whether a stock is equity, cash or speculative stock the planner must take into account the type of company and its performance. Diversifying the portfolio among the various stocks involving various level of risk assists to balance the portfolio. Moreover, the investor must understand the strong points and vulnerabilities of each stock of the portfolio.

References:

Brown, K. and Tiu, C., 2013. The interaction of spending policies, asset allocation strategies, and investment performance at university endowment funds (No. w19517). National Bureau of Economic Research.

Calza, A., Monacelli, T. and Stracca, L., 2013. Housing finance and monetary policy. Journal of the European Economic Association, 11(s1), pp.101-122

Gibson, R., 2013. Asset Allocation: Balancing Financial Risk: Balancing Financial Risk. McGraw Hill Professional.

Han, L., 2013. Understanding the puzzling risk-return relationship for housing. Review of Financial Studies, 26(4), pp.877-928.

He, P.W., Grant, A. and Fabre, J., 2013. Economic value of analyst recommendations in Australia: an application of the Black–Litterman asset allocation model. Accounting & Finance, 53(2), pp.441-470.

Martinsuo, M. and Killen, C.P., 2014. Value management in project portfolios: Identifying and assessing strategic value. Project Management Journal, 45(5), pp.56-70.

Mazzola, P. and Gerace, D., 2015. A Comparison Between a Dynamic and Static Approach to Asset Management Using CAPM Models on the Australian Securities Market. Australasian Accounting Business & Finance Journal, 9(2), p.43.

Plumb, M., Kent, C. and Bishop, J., 2013. Implications for the Australian economy of strong growth in Asia. Reserve Bank of Australia.

Reddy, W., Higgins, D., Wist, M. and Garimort, J., 2013. Australian industry superannuation funds: investment strategies and property allocation. Journal of Property Investment & Finance, 31(5), pp.462-480.

Speelman, C.P., Clark-Murphy, M. and Gerrans, P., 2013. Decision making clusters in retirement savings: Gender differences dominate. Journal of family and economic issues, 34(3), pp.329-339.

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