Portfolio Construction

Portfolio Construction refers to a process of selecting the optimum mix of securities such as stocks, bonds, mutual funds, and money market instruments, for the purpose of achieving maximum returns by making minimum risk or loss

There are well known two approaches to portfolio construction :

(a) Traditional Approach & (b) Modern Approach

Traditional Approach of Portfolio Construction :
Under this approach, the financial plan is evaluated with regard to the client needs in terms of income and capital appreciation and appropriate securities are selected to meet those needs.

It consists of five basic steps :

(1) Analysis of constraints: It involves analysis of constraints of the investor within which the objectives will be formulated. The constraints may be decided on the basis of:

  • Income needs –  Investors need for current income (to meet living expenses) and constant income (to offset the effect of inflation)
  • Liquidity needs –  Investors preference for liquid assets
  • Safety of Principal –  Safety of principal value at the time of liquidation
  • Time Horizon –  Life cycle stage and investment planning period of the investor
  • Tax Consideration – Tax benefits of investing in a particular asset
  • Temperament – Risk  bearing capacity of the investor

(2) Determination of objectives: It involves formulation of objectives within the given framework of constraints. Constraints reflect the risk bearing capacity and income requirements of the investor. Some common objectives of investors are:

  • Current Income
  • Growth in Income
  • Capital Appreciation
  • Preservation of Capital

All objectives cannot be achieved simultaneously, hence if an investor`s objective is capital appreciation, he must be ready to invest it securities  that have high risk  in order to get high returns.

(3) Selection of Portfolio: The optimum asset mix for an investor depends upon his investment objectives.

(4) Risk & Return Analysis: It involves analysis of risk and returns involved in following a particular course of action. Major risk  categories that an investor can tolerate are determined and efforts are made to minimize these risks to get expected returns.

(5) Diversification: It involves assigning relative portfolio weights to different securities  on the basis of which the portfolio is diversified.  Diversification is done on the basis of investors need of income and his risk bearing capacity. Industries that correspond to specific goals of the investor are selected, out of which few companies from each industry are chosen on the basis of its growth, profits, dividend, R&D, expected earnings, goodwill etc. Finally, the number of different stocks required to give adequate portfolio diversification are selected and the number of shares of each stock to be purchased are determined depending upon the size of portfolio.

Modern Approach of Portfolio Construction

he modern approach of portfolio construction also known as Markowitz Approach  emphasizes on selection of securities  on the basis of risk and return analysis. The financial plan of an individual is audited in terms of risks  and returns and efforts are made to maximize expected returns for a given level of risk.

Unlike traditional approach which considers an investors need for income or capital appreciation as basis for selection of stocks, the modern approach takes into account the investors needs in from of market return or dividend  and his tolerance for risks as basis for selection of stocks. Returns are usually measured in terms of market return and dividend and form the basis of selection of stocks.

Ten to Fifteen stocks are selected after thorough analysis  and expected risk and return is computed for each stock.  Stocks with good return prospects are selected and funds are appropriately allocated among different stocks according to the portfolio requirements (risk & return) of the investor.

An investor may adopt an active or passive approach to manage his portfolio. Under passive approach, the investor holds the securities  for a previously established holding period while an active approach involves continuous assessment of risk  and return of securities and replacing low performing securities with high performing securities over time.

Note : Not more than 10 Funds and 15 stocks are selected after thorough analysis and expected risk and return is computed for each fund / stock.