What is Portfolio Management?

Portfolio management is like hiring a tutor for a big test you’ve got coming up…

Let’s say you’ve been struggling a bit in science, and you want to make sure you do alright on the next test. You might hire a tutor to help you get back on track. Similarly, someone might hire a portfolio management to prepare for retirement or another big financial goal they’ve got their eyes on.

Portfolio management refers to all of the activities that go into managing an individual’s or organization’s investment portfolio. Portfolio management is also a career path within the finance industry. Portfolio managers work with clients to help them invest their money to reach their financial goals. Portfolio management includes tasks such as asset allocation, diversification, and rebalancing.

The strategy an investor or financial professional uses to manage a portfolio will vary depending on the specific financial goals and other individual preferences. In some cases, portfolio management is a relatively hands-off job, where the money goes into investments with few large-scale changes. In other cases, it’s a job that requires the professional to be more active because they are trying to outperform the market.

The primary objective of portfolio management is to help a client reach their short-term and long-term financial goals. A manager does this by taking into account many factors such as a client’s time horizon (meaning when they need the money) and their tolerance for risk.

Every client is different. Some portfolio managers work with huge nonprofit organizations with endowments. Others are working with individuals who want to send their kids to college and save for retirement. Whoever the client is, the portfolio manager tailors their strategy accordingly. Portfolio managers work to optimize returns and risks in a way that’s appropriate for each client’s goals.

The job of a portfolio manager is to increase returns for clients, while managing risk. Three primary tools that managers use to do that are asset allocation, diversification, and rebalancing.

Asset allocation is one of the most important jobs of a portfolio manager. It refers to how someone decides to divide up their whole portfolio. The asset allocation someone chooses will depend on a few different factors. First, your time horizon will impact your allocation. Time horizon refers to how long before you need the money. If you’re 20 and saving for retirement, your time horizon might be 45 years. This plays an important role in your asset allocation, as most people feel they can afford to take more investment risks the further they are from needing the money.

Another important part of asset allocation is risk tolerance, meaning how comfortable an investor is with taking on risk. Someone risk-averse may choose to stick with safer investments that have a lower return potential. Someone who’s comfortable with risk might prefer investments with a higher chance of loss, but a greater potential return.

Diversification is the act of splitting a portfolio up into different types of investments. Diversification is a critical part of asset allocation. Investing is an inherently risky activity. But putting your money into many different investments helps to spread the risk around. That way, if one of the investments goes south, you don’t lose all of your money.

Diversification happens at two different levels. First, investors can diversify between asset classes. This entails putting some of your money into stocks, bonds, cash, and alternative investments. The other step is to diversify within asset categories. So, rather than putting all of the money an investor has in stocks into the stock of a single company, they might choose to spread the money across different companies and industries. Mutual funds and exchange-traded funds can be an effective way to do this, as they invest in a variety of companies.

Rebalancing is an investment activity that investors do periodically to make sure their asset allocation is where they want it. Over time, the percentage of money you have in each investment category will change. Rebalancing allows you to reset the portfolio back to the initial preference.

Imagine an investor wants to put 50% of their money into stocks and the other 50% into fixed-income securities, such as bonds. The stocks see a greater rate of return than the bonds. After a while, 70% of that investor’s money is in stocks, while 30% is in bonds. If the investor wanted to maintain their 50/50 split, they’d move some of their stock returns over to their fixed-income investments.

When hiring someone to manage an investment portfolio, there are two primary strategies they can follow: active management and passive management. Investors don’t have to choose one or the other. If appropriate, a manager might actively manage a part of someone’s portfolio while putting the rest into passive investments.

Active portfolio management is a hands-on approach where the manager tries to beat a particular market index, such as the S&P 500. Active management requires a lot of forecasting, analysis and market research. Rather than focusing on buying and holding for the long term, active managers would be looking to make more frequent changes based on market trends, security prices or potential shifts. Active management can be a riskier investment strategy, but with the goal of obtaining greater returns. Because of the hands-on approach, active portfolio management is generally more expensive than its passive counterpart. Also, there’s no guarantee that active management will outperform the market; in fact, it’s statistically unlikely for an active manager to outperform the market — and you’ll still pay the higher fees

Passive portfolio management is more of a ‘set-in-and-forget it’ approach (not accounting for on-going maintenance activity). This type of investment involves buying into investments such as mutual funds, and ETFs. Those funds then invest in a variety of stocks and bonds typically duplicating an index. Passive portfolio management generally comes with lower fees, because the manager doesn’t have to be as hands-on.

Portfolio management looks different depending on the context. Still, some elements are relatively consistent.

Common steps include:

Step 1: Get to know the client’s goals. The first thing a portfolio manager will do when taking on a new client is to gain an understanding of that client’s goals. The investment needs of someone planning for retirement are very different from those of someone saving for the down payment on a house. These factors will play into the manager’s strategy. Another important thing for the manager to learn is the client’s risk tolerance

Step 2: Construct the portfolio. Once the manager understands the needs of the client, they can begin to make a plan. The manager will start by pinning down the best asset allocation for that client. Then they can put the plan into action by actually buying the investments on behalf of the client.

Step 3: Monitor and evaluate the portfolio’s performance. Once the manager has put the plan into action, they’ll continue to keep an eye on its progress. If the portfolio isn’t performing as expected, the manager might make some changes. This step also includes any rebalancing that the manager does down the road. Most portfolio managers will contact their clients annually to check for any material developments.

There’s no one right investment strategy for everyone. Each individual and organization has different goals and a different tolerance for risk, and therefore different investment needs. Portfolio management isn’t just about picking winning investments. Instead, it’s about learning the goals, timeline, and risk tolerance of each individual investor. Using that information, a manager can help to craft an investment strategy that fits the bill.

Even in the case of passive investing, portfolio management is about so much more than picking the right investments once and letting them sit until retirement. It’s about selecting the right asset allocation in the first place based on the needs of the client. Portfolio managers can help to ensure a well-diversified portfolio as time goes on by following up and checking the progress of a portfolio and rebalancing as necessary. Whether someone is working with a financial professional or handling their own investments, portfolio management is a critical step in reaching long-term investment goals.