Steps in the Portfolio Construction Process

The portfolio management process consists of a series of integrated activities carried out in a logical, systematic, and consistent way to create and sustain an optimal portfolio.

Steps in the Portfolio Construction Process

The key components of this process include planning, execution, and evaluation, which are outlined below:

1. The initial step in portfolio management is to develop a policy statement. This roadmap identifies your risk tolerance and outlines investment objectives, goals, and constraints.

2. The second step involves analyzing current financial conditions and predicting trends.

3. The third step is the construction of the portfolio, considering the policy statement and financial market forecasts. Given that your needs and market conditions are ever-changing, continuous monitoring and rebalancing of the portfolio are essential.

4. The fourth step focuses on measuring and evaluating performance.

The portfolio management process flows from planning to execution and ultimately to feedback.

1. Investment Policy Statement (IPS)

The creation of an Investment Policy Statement (IPS) is a crucial step in portfolio management. The IPS serves as a roadmap that directs the investment process. It is crafted by either your or their investment advisors, outlining specific investment objectives, goals, constraints, preferences, and the level of risk they are willing to accept. All investment decisions are made per the IPS, considering your goals, objectives, and risk tolerance. Since your' needs can evolve, it is essential to periodically update and revise the IPS.

Components of IPS

The Investment Policy Statement (IPS) is essential for you and should be created thoughtfully. The IPS typically outlines your goals, priorities, investment objectives, and time horizon. It should detail your risk/return profile, liquidity needs, and preferred asset classes. Additionally, a systematic review process is crucial for keeping you aligned with their goals, emphasizing the importance of current information for effectiveness.

a. Investment Objectives

You evaluate your goals based on risk, return, and liquidity, with risk and return positively correlated, while liquidity inversely relates to return. Common objectives include capital preservation, regular income, and capital appreciation, which inform asset allocation. For capital appreciation, you may choose high-risk equities, while for capital preservation, safer bonds or debt securities are favoured. If regular income is the aim, investments are often directed toward dividend stocks, interest-generating bonds, or rental properties.

b. Investment Constraints

Constraints refer to limitations that prevent you from accessing specific investment opportunities. These constraints are connected to factors such as liquidity requirements, time horizons, and other individual needs and preferences.

c. Liquidity constraint

People have varying liquidity needs, with younger individuals generally requiring less than older ones. Factors such as health issues or upcoming expenses can influence these requirements.

Liquidity needs can be categorized into:

• Emergency Cash: Typically two to three months' worth of expenses, more if income is unstable.

• Near-Term Goals: Funds for goals within a year should be kept in liquid, low-risk assets.

• Investment Flexibility: Higher liquidity is needed to seize market opportunities.

A portion of the investment portfolio should be in cash or cash equivalents.

d. Regulatory constraints

Individuals face minimal regulatory restrictions but must comply with existing regulations, which can limit investment options. For example, insider trading based on non-public information is prohibited for company insiders.

e. Tax Constraint

The investment process is complicated by tax considerations, as taxes impact portfolio management and investment decisions. Different investments and income types face varying tax treatments, such as interest, dividends, rents, and capital appreciation. Additionally, tax liabilities can vary based on the recipient's tax bracket.

f. Unique needs and preferences

People have unique concerns influenced by personal, social, ethical, cultural, or preference-based beliefs. For example, some may avoid investing in companies with harmful environmental practices or feel emotionally attached to their employer's stocks.

2. Evaluation of your Needs and Requirements

You allocate resources to meet various goals, which differ in time frame and priority. Evaluating your needs is crucial for informed investment decisions.

• High Priority Near-Term Goals:

  • Significant emotional weight.

  • Must be achieved within a few years.

  • Typically involve cash equivalents or fixed-income instruments to minimize risk.

• Long-Term Goals:

  • Building a retirement fund is a common high-priority goal.

  • Requires early planning and a diversified investment strategy.

• Low Priority Goals:

  • Aspirations like buying a farmhouse or luxury vehicle.

  • Can employ more aggressive investment strategies as they are less distressing if unfulfilled.

3. Analysing your financial position  

A practical way to assess financial standing is by creating personal financial statements, which include a net worth statement and income-expense statements.

To calculate net worth:

• List all assets (e.g., house, car, investments, savings, jewellery) at estimated market value.

• Subtract total liabilities (e.g., loans, credit card debt) from total assets to find net worth.

  
  

It's recommended to calculate net worth annually. Next, evaluate if income exceeds expenditures, which indicates available funds for investment, tracked through a monthly income-expenditure statement.

Portfolio Construction Principles

The portfolio construction process is guided by your requirements, goals, and the timeline for achieving them.  

a. Selecting Equity portfolios

Equity portfolios should balance risk and stability based on investor needs. Large-cap stocks offer stability, while mid and small-cap stocks provide the potential for higher capital appreciation despite volatility. You should adjust your stock mix according to your risk tolerance. Stocks with higher dividend yields can also generate cash flow. The level of equity exposure should align with your goals and timeline.

b. Selecting Debt portfolios

When selecting a debt portfolio, prioritize generating consistent cash flow and choose specific instruments. Utilize short-term debt for immediate financial goals, as even brief investments can offer better returns than bank accounts. Your tolerance for credit risk will also impact the instruments in a medium to long-term debt portfolio.

c. Selecting Hybrid portfolios

Hybrid portfolios balance investment stability and potential gains by combining various assets. They are tailored to meet specific objectives, especially as long-term goals near, allowing you to achieve targets without separately selecting debt and equity. This transition aids in adjusting asset allocation seamlessly.

d. Other portfolios

Other portfolios will have added elements in them which could include assets like gold or other precious metals and even alternative investments. These portfolios are looking to raise the overall return but at the same time provide a different kind of exposure leading to diversification. This can be helpful for you in reducing their risk and maintaining stability.

Strategic versus Tactical Asset Allocation

Strategic asset allocation (SAA) involves long-term investment decisions based on your requirements, creating a target asset allocation among various asset classes to achieve goals.

In contrast, tactical asset allocation (TAA) focuses on short-term adjustments to capitalize on market opportunities. TAA allows you to shift funds between asset classes based on market conditions, aiming to outperform the market, while SAA emphasizes staying invested over time. Rebalancing is necessary after TAA adjustments to maintain the target allocation.

4. Rebalancing of Portfolio

Portfolios need regular monitoring and periodic rebalancing due to price fluctuations in holdings. Different asset classes produce varying returns, which can change the portfolio's overall asset allocation. Rebalancing helps maintain the original risk-return profile and may be necessary with changes in your goals or risk tolerance.  

Investors typically evaluate products after determining the objective. When constructing a portfolio, the first step is to define the objective, then develop an asset allocation plan. Product selection is done subsequently.