Portfolio Selection
Portfolio analysis provides the input for the next phase in portfolio management, which is portfolio selection. The proper goal of portfolio construction is to generate a portfolio that provides the highest returns at a given level of risk. A portfolio having this characteristic is known as an efficient portfolio. The inputs from portfolio analysis can be used to identify the set of efficient portfolios. From this set of efficient portfolios the optimum portfolio has to be selected for investment. Harry Markowitz portfolio theory provides both the conceptual framework and analytical tools for determining the optimal portfolio in a disciplined and objective way.
Portfolio Revision
Once the portfolio is constructed, it undergoes changes due to changes in market prices and reassessment of companies. Portfolio revision means alteration of the composition of debt/equity instruments, shifting from the one industry to another industry, changing from one company to another company. Any portfolio requires monitoring and revision. Portfolios activities will depend on daily basis keeping in view the market opportunities. Portfolio revision uses some theoretical tools like security analysis, Markowitz model, Risk-Return evaluation.
Portfolio revision involves changing the existing mix of securities. This may be effected either by changing the securities currently included in the portfolio or by altering the proportion of fund invested in the securities. New securities may be added to the portfolio or some of the existing securities may be removed from the portfolio. Portfolio revision thus, leads to purchasing and sales of securities. The objective of portfolio revision is the same as the objective of portfolio selection, i.e maximizing the return for a given level of risk or minimizing the risk for a given level of return. The ultimate aim of portfolio revision is maximization of returns and minimizing of risk.
Having constructed the optimal portfolio, the investor has to constantly monitor the portfolio to ensure that it continues to be optimal. As the economy and financial markets are dynamic, changes take place almost daily. As time passes, securities, which were once attractive, may cease to be so. New securities with promises of high returns and low risk may emerge. The investor now has to revise his portfolio in the light of the development in the market. This revision leads to purchase of some new securities and sale of some of the existing securities from the portfolio. The mixture of security and its proportion in the portfolio changes as a result of the revision.
Portfolio revision may also be necessitated some investor related changes such as availability of additional funds, changes in risk attitude need of cash for other alternative use etc.
Whatever be the reason for portfolio revision, it has to be done scientifically and objectively so as to ensure the optimality of the revised portfolio. Portfolio revision is not a casual process to be carried out without much care. In fact, in the entire process of portfolio management portfolio revision is as important as portfolio analysis and selection. In portfolio management, the maximum emphasis is placed on portfolio analysis and selection which leads to the construction of the optimal portfolio. Very little discussion is seen on portfolio revision which is as important as portfolio analysis and selection.
Portfolio revision involving purchase and sale of securities gives rise to certain problem which acts as constraints in portfolio revision, from those constraints some may be as following:
- Statutory Stipulations: Investment companies and mutual funds manage the largest portfolios in every country. These institutional investors are normally governed by certain statutory stipulations regarding their investment activity. These stipulations often act as constraints in timely portfolio revision.
- Transaction Cost: Buying and selling of securities involve transaction costs such as commission and brokerage. Frequent buying and selling of securities for portfolio revision may push up transaction cost thereby reducing the gains from portfolio revision. Hence, the transaction costs involved in portfolio revision may act as a constraint to timely revision of portfolio.
- Intrinsic Difficulty: Portfolio revision is a difficult and time-consuming exercise. The methodology to be followed for portfolio revision is also not clearly established. Different approaches may be adopted for the purpose. The difficulty of carrying out portfolio revision it self may act as a restriction to portfolio revision.
- Taxes: Tax is payable on the capital gains arising from sale of securities. Usually, long term capital gains are taxed at a lower than short-term capital gains. To qualify as long-term capital gain, a security must be held by an investor for a period not less than 12 months before sale. Frequent sales of securities in the course of periodic portfolio revision of adjustment will result in short-term capital gains which would be taxed at a higher rate compared to long-term capital gains. The higher tax on short-term capital gains may act as a constraint to frequent portfolios.