After listening to a financial news show, a bright-eyed investor sits down to buy their first stock. They take a look at balance sheets and dividend yields and feel confident in their final decision. With a few simple keystrokes—bam! We have a new investor on our hands!
Everyone needs to get started somehow, and dabbling in a stock purchase or two is one way to do it. But as an investor develops skill, they may want to consider the widely accepted tenets of building out a comprehensive investment strategy.
Portfolio Management Defined
What is portfolio management? With investing, portfolio management involves a portfolio manager selecting and maintaining a group of investments with your financial objectives and risks tolerance in mind. Often, portfolio managers use historical investment returns (and risk) as a guide.
Broadly speaking, passive portfolio management is a strategy that tracks an external market index. The goal is not to beat the market’s daily performance, but rather to mirror it and to diversify investments for the long-term. Common examples include ETFs, index funds, and equity mutual funds. Passive portfolios typically come with lower management fees.
Not all of the tools of professional investment portfolio management are widely accessible to individual investors. For instance, professional investment managers often have access to analytical research, advanced algorithms, and costly industry tools.
When building out an investment portfolio, investors may find it helpful to keep some of the following foundational ideas of portfolio management in mind. These tenets include the use of a benchmark, asset allocation, and rebalancing in order to build a diversified strategy.
Further, investors may want to learn the distinction between passive and active portfolio management, along with the variety of ways to implement their desired strategy.
Active portfolio management is generally handled by a professional money managers.. They regularly track investors’ portfolio performance—deciding when to hold, buy or sell various investments. Here, the investment goal is to outperform (not mirror) the market’s day-to-day ups and downs. Professionally invested portfolios often come with higher management fees, which are usually passed on as an added cost to the investor.
Important Portfolio Management Strategies to Know
“Don’t put all your eggs in one basket,” so the old investing adage goes. The idea here is that it’s risky to bank on any one type of investment, no matter how sure of it the investor may feel.
In investment portfolio management, portfolio diversification is the technique of buying multiple different, non-correlated investment types in order to lower a portfolio’s overall risk.
This makes a lot of sense when thinking of owning just one stock—anything could happen to this company.
Worst case scenario, it could cease to exist at all, and then all money in the investment is lost. It would not be wise to rest an entire investing strategy on the fate of just one company. By owning a bunch of stocks, the poor performance of one won’t sink the ship.
A properly diversified strategy can help sap some of the risks at every level of investment portfolio management—starting with the big-picture decision of whether to own stocks in the first place, and in what proportion. By integrating other asset classes into a portfolio, it may help to lower overall risk by lowering the exposure to a single asset type.
For example, an investor may find it too risky to invest all of their money in the stock market, so they look to integrate bonds, real estate, and even cash into their strategy. That way, when the stock market takes a big dip, the investor won’t see the entire value of their portfolio go down in lockstep. It may even be possible for other asset classes to gain while stocks fall.
This way, an investor will not be stuck with a portfolio that moves unanimously in one direction—called correlated returns. Said another way, when one investment “zigs,” the other might “zag,” balancing out extremes. (This may be especially helpful during a stock market crash, when dramatic price movement is most pronounced—and the most painful.)
An investor could further diversify within each asset class. Within the stock market, that might mean owning stocks within different industries (sometimes called “sectors” in the stock market), in different countries, and with varying investment “styles”—such as growth, value, or dividend-paying stocks.
For example, it may be less risky to own stocks that exist across all of the sectors than to own only stock in a single sector, like technology or health care.
Within the bond market, it is possible to own corporate and government bonds (treasury or municipal), along with bonds of varying maturities.
One simple way to achieve diversification might be to use pooled investment funds, like mutual funds or ETFs (exchange-traded funds), that are inherently diversified. For example, it is possible to buy an ETF that holds hundreds of stocks from around the world, in proportions that mimic the overall market.
How does one determine how much to allocate to stocks, bonds, cash, and so on? This is the question of asset allocation.
Asset allocation is an investor’s breakdown of holdings by asset class; the big-picture investing decision mentioned above.
One of the most important decisions that investors will make is not whether to buy this stock or that stock, but instead—whether to be invested at all. And if they are making the decision to invest, which investment types are most appropriate.
The most common asset classes are stocks, bonds, and cash. When investing within a workplace retirement account, like a 401(k), asset allocation usually boils down to a mix of stocks and bonds. (Tip: Within retirement accounts, these asset classes may be referred to as equities and fixed income, respectively.)
Generally, asset allocation is determined by an investor’s goals, risk tolerance, and investing timeline. This is where investors might want to start, asking themselves questions like: What is my goal with this money? When will I need the money? And what type of risk am I willing to take?
Then, they can piece together those answers with the asset type, or blend of asset types, that make the most sense given each type’s typical performance and risk profiles.
For example, a person targeting long-term growth and who is comfortable with risk may have a higher percentage of their portfolio allocated to the stock market, which has higher risk with a higher potential for return.
Someone who is nearing retirement and wants a more conservative strategy may have more allocated to bonds and cash.
Imagine an investor with a “70/30” allocation, with 70% of their portfolio invested in stocks and 30% invested in bonds. If this person had $10,000 invested, that’s $7,000 invested in stocks and $3,000 in bonds. (It may help to visualize this as a pie graph!)
Once an asset allocation is determined, the idea is to stick with it. Because remember, asset allocation is determined by an investor’s goals—not what is currently going on in the market.
Over time, different asset classes and investment types grow unevenly. The point of diversification is to have investments that perform differently during different times and in different environments.
Therefore, asset allocations may get out of whack after a period of uneven growth. What remains could be a portfolio that no longer matches up with an investor’s goals. In order to keep a portfolio’s “balance” in check, the proportions may need to be readjusted.
This process is called rebalancing.
Using the “70/30” example above, say that the portfolio’s stock piece grew faster than the bonds. After the disproportionate growth, stocks now make up 90% of the overall portfolio allocation, and bonds make up just 10%.
But this investor had already determined that a 70/30 split was more appropriate for their goals and risk tolerance.
To rebalance, the investor would sell the overweight in stocks and buy back into bonds, which are currently under their desired weight. Or the investor could add to the lagging investment.
In several ways, occasional rebalancing helps encourage good investor behavior. For one, it encourages an investor to stick to a long-term plan. This may help when it is tempting to make decisions based on the market’s current activity, which is often a bad idea.
Second, it encourages selling high and buying low. This can feel counterintuitive, because rebalancing may require the investor to sell out of the asset class that has been performing best and to buy into the one that has performed worse.
Easier said than done because humans can exhibit what is called a recency bias, naturally favoring the investment that has performed best in the recent past. But the recent past cannot necessarily predict what will happen in the future.
There are different opinions on how often an investor should rebalance. It can be done monthly, quarterly, or annually, or on an as-needed basis as the portfolio grows over time.
Using a Benchmark in Portfolio Management
Portfolio managers often use a benchmark to measure risk and performance. Often, a benchmark is a broad market index for the investment’s corresponding market—like comparing a stock portfolio to a stock index.
For example, if an investor is building a portfolio of U.S. stocks, they might want to use the S&P 500 as benchmark. The S&P 500 is a broad market index that measures the performance of the U.S. stock market.
For a global stock portfolio, the MSCI World is a popular benchmark. For bonds, some portfolio managers may use one of Bloomberg Barclays bond indices.
A benchmark is not only used to measure performance, but also to manage risk. When an investor builds a portfolio that they hope will best the market index (that’s active management—more on that below), they are also taking the risk that it could do worse. The further from the benchmark a portfolio deviates, the higher potential for risk.
Passive and Active Portfolio Management
When it comes to portfolio management, there are two schools of thought on just how much of a role the manager should take: passive and active portfolio management.
With a passive approach, the portfolio manager or investor looks to simply return the average of the markets that they’ve invested in.
To do this, they may buy a broad market index fund. For example, an investor who wants to return the average of the U.S. stock market could buy an index fund such as an S&P 500 index fund or a total U.S. stock market index fund.
Passive investing is popular among investors who believe in a long-term, set-it-and-forget-it strategy. Such an investor may also believe that active management is a futile endeavor, as active managers ultimately tend to do worse than the stock market’s average, anyway. Index funds are also generally lower in cost and have outperformed their managed peers.
There are a number of reasons that a person would pursue active portfolio management—the primary being that it gives the investor the chance to “beat the market.” Instead of investing in the whole market via an index fund or similar strategy, an investor chooses only the investments that they believe will perform the best.
The reverse could also be true—an investor could choose to invest in what they perceive as “safer” stocks or other investments.
Said simply, active managers are picking and choosing their investments.
Another reason some investors may go the active route is because they get enjoyment out of actively managing their investment portfolios. Others may do it to build out their investing experience or to gain comfort with the transaction process.
Also, some investors may be using an active management strategy without realizing it: Some mutual funds are actively managed and charge a management fee for the service.
Whether investors go with an active or passive strategy, it is still worth considering the tenets of investment analysis and portfolio management discussed here: diversification, asset allocation, rebalancing after periods of uneven growth, and the use of a benchmark.
Building a Portfolio Strategy
These days, there are plenty of options for investors looking to build out portfolios, ranging from DIY methods to pre-built portfolio strategies offered by robo advisor services.
For a DIY approach, an investor can open an account at a brokerage bank or use a trading platform, like SoFi Active Investing, which lets investors choose the stocks they’re interested in buying.
Robo advisor services build out a portfolio strategy on behalf of the investor. First, the investor answers questions about their goals, risk tolerance, and investing timeline, which are then input into an algorithm that creates an investment management strategy. Generally, robo advisors use low-cost index ETFs to create the portfolio’s strategy.
For more on how a robo strategy works, check out SoFi Automated Investing. No matter what strategy investors choose, the most important thing is getting started.
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