Building the Investment Portfolio

Portfolio management involves the constant and systematic management of financial assets according to the investor's objectives and his or her capacity to bear risks. In the majority of cases, this is achieved through a balanced portfolio. A balanced portfolio is established by combining "defensive securities" (those chosen for security and income) and "dynamic securities" (those which provide increased opportunity for capital appreciation like growth stocks). A balanced portfolio is designed in relation to the evolution in capital markets with the intention of securing an optimal return on investment.

In order to ensure efficient management of a portfolio, regardless of its nature or composition, the fund manager must have a much deeper knowledge base and dedicate much more time and effort to the process than required by the simple buying and selling of individual holdings. The manager must carefully study and periodically re-evaluate the investor's objectives, acceptable levels of risk and overall financial situation, as well as remain aware of all applicable tax legislation that affect investors. Building a portfolio is a five-step process, each step being absolutely essential to achieving the true objective of portfolio management, which is to maximize total return while keeping in consideration the investor's ability to assume risk. These five steps are:

1. assessing the investor's personal situation;
2. identifying investment goals; 
3. deciding on the asset mix;
4. building a portfolio, and
5. managing the portfolio.

Assessing the Investor's Personal Situation

Because investment decisions are made with the objective of meeting the investor's particular needs, the investment management process must always begin with a complete investor profile. Only by studying all the factors that may affect the investment strategy can the manager make informed recommendations and efficiently manage the portfolio. Included in these factors are a wide variety of personal characteristics such as age, health, financial situation, tax bracket, family commitments and responsibilities, investment knowledge and risk tolerance.

The personal financial planning exercise helps the investment advisor become more familiar with the client's background.

Identifying Investment Goals

Investors can choose among several types of securities, for which the income and security level, the potential for return and the negotiability vary. As these variables are not equally important to the investor, assets must be chosen or recommended with precise objectives in mind. This is why the client's needs or objectives must be clearly defined before building the portfolio.  An analysis of the investor's main characteristics will help the portfolio manager ensure that the objectives are both appropriate and realistic.

There are primary and secondary investment goals. Primary goals (such as income, capital appreciation and investment security) will indicate which class of securities will predominate in a portfolio, and secondary goals (such as tax reduction and negotiability) will indicate which specific securities within these classes should be selected. However, market forecasts also play an important factor in the final composition of the portfolio.

Deciding on the Asset Mix

The third and most important step in managing a balanced portfolio is determining the optimal asset mix. The investment capital must be distributed among several asset classes, taking into account the expected rate of return for each class. For example, if common shares seem to be the most attractive security class, they should be given a predominant place in the portfolio.

Recommendations concerning asset mix are normally determined for periods of up to 12 months. Recommendations made over a longer period are somewhat less reliable as the economy and capital markets are in constant flux. For this reason, factors influencing asset mix must remain under constant scrutiny and the asset mix adjusted immediately once market conditions affect the relative attractiveness of the various asset classes. Furthermore, since the portfolio should always reflect asset mix recommendations, the changes made quite often justify the buying or selling of a particular security.

Portfolio managers may choose among three overall asset classes: cash and cash equivalents, fixed income securities and stocks. The first class includes short-term fixed income securities such as treasury bills, term deposits and commercial paper. The second group consists of bonds, debentures, preferred shares and mortgage securities. The third category includes common shares, rights and warrants.

Asset mix and investment goals are determining factors in building a balanced portfolio.  The asset mix determines which overall asset class should be bought or favoured, whereas investment goals determine the specific type of holdings desired within each class. As a result, a given investment within a balanced portfolio may seem unsuited to the overall investment goals. For example, if an investor's primary goal is capital appreciation or increased total return, but fixed income securities are the most attractive holding, the total return on investment can only be maximized by purchasing fixed income securities. Even if income is not a priority for the investor, the portfolio must continue to be made up, for the most part, of fixed income securities in order to achieve the investor's overall goals.

In attempting to secure a maximum return on investment in a balanced portfolio, it is more important to favour the right asset class than it is to beat the index or obtain a higher-than-average return in each class. This proves to be especially true when capital markets are unstable.

Determining an asset mix is a complex decision and is based on a comparative analysis of all the capital markets. This decision must take into account all the elements that can influence an asset class, including anticipated private and public sector activities, on both the domestic and international scale. One must closely study and be able to interpret government policy, corporate earnings, the economic situation and market conditions.

As these factors are very complex and open to interpretation, it is extremely difficult to predict with any accuracy the magnitude of the fluctuations in any given class. For this reason, recommendations concerning asset mix in a balanced portfolio aim for specific proportions, i.e. a pre-determined minimum and maximum percentage for each asset class. This method not only highlights that the future is extremely difficult to predict, but also provides the manager with the flexibility necessary to meet the different needs of each client or to seize specific investment opportunities as they arise.

Risk Management

The portfolio manager's role is to build a portfolio which will provide the investor with the best possible rate of return while still taking into account the individual's pre-determined level of risk. However, as fluctuations in the stock market or in interest rates (i.e. fixed income security markets) are not within the portfolio manager's control, risk management is a fundamental aspect of portfolio management. As risk is the only variable which can truly be controlled in the risk/return ratio, the portfolio manager looking to increase the rate of return must take into account the corresponding increase in the level of risk.

Building a Portfolio

After developing a solid understanding of the client and his or her specific investment goals, deciding on the asset mix and determining the level of risk that the client is ready to assume, the portfolio manager can begin to build the portfolio. If these facts are incomplete, the portfolio will be poorly structured and will damage the manager-client relationship.

Asset mix is the cornerstone of the building process, since it is the most important factor in establishing a balanced portfolio. It determines the overall proportions of each asset class, whereas more specific investment goals are responsible for defining the final percentages and the specific securities within each class. For example, if it has been determined that equities should represent between 40% and 60% of the portfolio, then this percentage must be respected. However, investment goals will ultimately determine if these proportions correspond to the requirements.

The portfolio manager chooses liquid assets according to his or her predictions regarding fluctuations in short-term interest rates, all the while taking into account the client's acceptable risk. If a short-term drop in the interest rate is forecast, 90 or 180-day terms will be preferred over 30-day ones. Once the term has been determined, a specific security must be chosen according to the acceptable level of risk for the client.  However, as the differences in return for short-term investments are negligible, and because most portfolios contain a minimum of short-term investments, Canadian treasury bills usually satisfy the investment goals of the majority of clients in this class.

The fixed income securities portion of a portfolio should consist of medium-term securities that have the potential to yield solid returns taking into account expected fluctuations in interest rates and the client's acceptable level of risk. Consequently, if an increase in interest rates is forecast, the duration of fixed income securities should be shortened, thereby reducing the client's risk. On the other hand, if a drop is anticipated, the term should be extended in order to boost the potential for return.

Once the terms or the percentage allocated to each term have been determined, the investor's objectives will determine which securities would best suited. Thus, the investor looking for security will prefer to invest in government issues. The investor looking to maximize his or her after-tax returns will buy bonds at below-par value or preferred shares. The more dynamic investor could decide to concentrate on a specific term and opt for either convertible or regular corporate securities.

Once the exact percentage of the equity portion of the portfolio has been determined, the choice remains as to which securities best meet the investor's objectives within the pre-determined risk limit. If the client's objectives are to secure an income and protect his or her capital, the recommended percentage of equity participation will be minimal and more secure stocks will be purchased. If the investor values capital appreciation above all and is prepared to accept a higher level of risk, then growth and speculative stocks will have a more prominent place in the portfolio.

In order to structure the equity portion of the portfolio, one must determine which sectors and which markets are the most attractive and which specific holdings within these categories best meet the investor's needs. Although the assessment of the relative attractiveness of each industry sector and of each market is the most popular method of selection, securities can be classified in other ways. Equities can be categorized according to certain characteristics inherent to industry sectors, such as whether the industry in question is cyclical or non-cyclical, whether it is more or less susceptible to variations in interest rates or whether it is more or less capitalistic or subject to government regulations. Regardless of the classification system used, the effective portfolio manager must first decide on general categories and then on the specific equities.

Portfolio Management

Building a portfolio is only the first step. Portfolio management, however, is a continuous process. It is therefore essential to establish a system that allows a constant re-evaluation of the appropriateness of each individual holding and of the overall investment strategies. The manager must monitor changes in the investor's goals, financial situation and preferences on the one hand while monitoring corporate and capital market forecasts on the other.

Most importantly, the portfolio manager must know his or her client objectives. The investor's risk tolerance, tax bracket or need for liquid assets or savings can change over time. The client's general profile must therefore be updated on a regular basis.

Capital markets are also in constant flux, reflecting changes in government or central bank policies, economic growth or stagnation, and shifts in the prosperity of various industry sectors. The portfolio manager must be on top of the direction of monetary policies, forecasts for GNP and inflation rates, changes in consumer needs and spending on fixed assets, as well as the possible effects that these factors may have on asset allocation or on individual securities within a portfolio. The portfolio manager's challenge is to anticipate changes and to systematically modify the portfolio so that the client's goals and expectations in terms of returns are respected. Any changes made must follow the same principles as those used in building the portfolio.