Portfolio (finance)

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In finance, a portfolio is a collection of investments held by an institution or an individual.

Holding a portfolio is a part of an investment and risk-limiting strategy called diversification. By owning several assets, certain types of risk (in particular specific risk) can be reduced. The assets in the portfolio could include bank accounts, stocks, bonds, options, warrants, gold certificates, real estate, futures contracts, production facilities, or any other item that is expected to retain its value.

In building up an investment portfolio a financial institution will typically conduct its own investment analysis, while a private individual may make use of the services of a financial advisor or a financial institution which offers portfolio management services.


[edit] Management

Portfolio management involves deciding what assets to include in the portfolio, given the goals and risk tolerance of the portfolio owner. Selection involves deciding which assets to acquire/divest, how many to acquire/divest, and when to acquire/divest them. These decisions always involve some sort of performance measurement, most typically the expected return on the portfolio, and the risk associated with this return (e.g., the expected standard deviation of the expected return). However, due to the almost-complete uncertainty of future values, this performance measurement is often done on a casual qualitative basis, rather than a precise quantitative basis (which would give a false sense of precision). Typically the expected return from portfolios of different asset bundles are compared.

The unique goals and circumstances of the investor must also be considered. Some investors are more risk averse than others.

Mutual funds have developed particular techniques to optimize their portfolio holdings. See fund management for details.

[edit] Portfolio formation

Many strategies have been developed to form a portfolio; among them:

[edit] Models

Some of the financial models used in the process of valuation, stock selection, and management of portfolios include:

[edit] Returns

There are many different methods for calculating portfolio returns. A traditional method has been using quarterly or monthly money-weighted returns. A money-weighted return calculated over a period such as a month or a quarter assumes that the rate of return over that period is constant. As portfolio returns actually fluctuate daily, money-weighted returns may only provide an approximation to a portfolio’s actual return. These errors happen because of cashflows during the measurement period. The size of the errors depends on three variables: the size of the cashflows, the timing of the cashflows within the measurement period, and the volatility of the portfolio[1].

A more accurate method for calculating portfolio returns is to use the true time-weighted method. This entails revaluing the portfolio on every date where a cashflow takes place (perhaps even every day), and then compounding together the sub-period returns.

[edit] Attribution

Performance Attribution explains the active performance (i.e. the benchmark-relative performance) of a portfolio. For example, a particular portfolio might be benchmarked against the S&P 500 index. If the benchmark return over some period was 5%, and the portfolio return was 8%, this would leave an active return of 3% to be explained. This 3% active return represents the component of the portfolio's return that was generated by the investment manager (rather than by the benchmark).

There are different models for performance attribution, corresponding to different investment processes. For example, one simple model explains the active return in "bottom-up" terms, as the result of stock selection only. On the other hand, sector attribution explains the active return in terms of both sector bets (for example, an overweight position in Materials, and an underweight position in Financials), and also stock selection within each sector (for example, choosing to hold more of the portfolio in one bank than another).

An altogether different paradigm for performance attribution is based on using factor models, such as the Fama-French three-factor model.

[edit] References

  1. ^ [1] Investment Performance Measurement Errors, accessed 2008-06-29.

[edit] See also

[edit] External links

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