Risk drives return. So, the practice of investing and managing portfolios should focus primarily on managing risk rather than returns. Let us discuss about the portfolio management process. Asset allocation is the process of deciding how to distribute an investors wealth among different asset classes for investment purposes. An asset class consists of instruments that have similar characteristics, attributes and risk-return relationships. A broad asset class like that of bonds can be divided into smaller asset classes such as government bonds, corporate bonds and high-yield bonds. The asset allocation decision is not an isolated choice; rather, it is a component of the portfolio management process. Let us take an overview of the portfolio management process.
Investment policy statement
The first step in the process is to develop an investment policy statement, or plan, that will guide all future decisions. Much of an asset allocation strategy depends on the investor's policy statement, which includes his goals or objectives, constraints and investment guidelines. Irrespective of who the investor is or how simple or complex the investment needs are, one should develop a policy statement before making long-term investment decisions. The policy statement is a road map where in the investor specifies the type of risks he is willing to take and his investment goals and constraints. All investment decisions are based on the policy statement to ensure they are appropriate for the investor. As investor needs change over time, the policy statement must be periodically reviewed and updated.
Investment strategy will jointly be determined by the factors such as investor needs, as reflected in the policy statement and financial market expectations. Economies are dynamic and they are affected by numerous industry struggles, politics and changing demographics and social attitudes. Thus, the portfolio will require constant monitoring and updating to reflect changes in financial market expectations.
The third step is construction of the portfolio. With the investment policy statement and financial market forecasts as input, the investor needs to implement the investment strategy and determine how to allocate available funds across different asset classes and securities. This involves constructing a portfolio that will minimise the investor's risks while meeting the needs specified in the policy statement.
The fourth step is the continuous monitoring of the investor's needs and capital market conditions. As and when necessary, the policy statement needs to be updated. Based upon all of this, the investment strategy is modified accordingly. A component