Portfolio construction and management

Learn how to build and maintain a diversified portfolio that aligns with your risk appetite and financial goals.

25 June 2024

Portfolio construction and management
  • Portfolio construction aims to create a balanced portfolio of different assets from different sectors

  • The goal is to maximise profits whilst protecting your capital - by reducing the impact of one asset’s poor performance

  • Goal setting, risk assessment, asset allocation and security selection are key steps in creating and managing a diversified portfolio

  • Portfolio management can be divided into active and passive strategies, where active management involves proactive decision-making that aims to outperform benchmarks, while passive management tracks specific indices with minimal intervention

Introduction to portfolio construction

Portfolio construction is a critical aspect of trading and investment management that involves the strategic assembly of various financial assets to achieve specific financial objectives while managing risk.

It refers to the process of combining different investments in a way that optimises returns based on investor's goals, risk tolerance, and time frame.

The primary goal of portfolio construction is to create a well-diversified and balanced investment portfolio that maximises returns while minimising risk. Diversification entails the distribution of investments across various securities or sectors to minimise overall risk of the portfolio. Constructing a well-diversified portfolio aims to mitigate the impact of underperforming assets, fostering stability in case of unexpected market movements.

Well-constructed portfolio and its efficient management are keys to long-term success in financial markets as it’s the foundation of disciplined trading and investing. Whether you are just starting to build your portfolio or looking to diversify your current one, this article offers insights for managing your assets and building more strategic portfolios.

How to build a diversified portfolio

Let’s have a look at the key steps in building a portfolio that fits your financial goals and risk appetite.

Goal setting: Investors begin by defining their financial goals, such as capital appreciation, income generation, or capital preservation. Understanding the purpose of the investment helps determine the appropriate asset allocation.

Risk assessment: Evaluating your risk tolerance is the next step. Consider factors, such as age, financial situation, and willingness to withstand market fluctuations. This assessment guides the selection of assets with varying risk levels.

Asset allocation: Based on their goals and risk tolerance, investors and traders allocate their funds across different asset classes, such as stocks, bonds, real estate, and cash equivalents. Asset allocation is a critical determinant of portfolio performance.

Security selection: Once asset classes are chosen, investors select specific securities or investments within each category. Factors such as company fundamentals, industry trends, and market conditions influence these choices.

Managing your portfolio

Creating your portfolio is just the beginning. After you’ve selected your assets, ongoing management is important so that your portfolio remains consistent with your goals and financial situation.

Rebalancing: Portfolios need periodic adjustments to maintain the desired asset allocation. Rebalancing involves selling overperforming assets and buying underperforming ones to bring the portfolio back in line with its target allocation.

Monitoring and reviewing: Regularly monitoring the portfolio's performance and assessing its alignment with financial goals is crucial. Market conditions, economic changes, and personal circumstances may require adjustments.

Risk management: Implementing risk management strategies, such as using stop loss orders or adding hedging instruments, can help protect the portfolio from significant losses.

Cost considerations: Investors should be mindful of transaction costs, management fees, and other expenses associated with portfolio construction and management. Minimising costs can contribute to better overall returns.

Tax efficiency: Consideration of tax implications is essential. Strategies like tax-loss harvesting or investing in tax-efficient funds can help optimise after-tax returns.

Two approaches to portfolio management

Portfolio management can be approached through two methods: Active and passive strategies.

Active and passive managed portfolios represent two different investment management approaches. In an active portfolio management strategy, fund managers actively make investment decisions with the goal of outperforming a specific benchmark or index. These managers engage in extensive research, market analysis, and actively trade securities to capitalise on perceived market inefficiencies. The success of an active portfolio relies on the manager's skill in selecting investments and timing the market.

On the other hand, passive portfolio management involves tracking a specific market index or benchmark rather than attempting to outperform it. Passive managers aim to replicate the performance of the chosen index by holding a portfolio that mirrors its composition. This strategy is often associated with lower management fees and trading costs compared to active management, as there is less frequent buying and selling of securities.

The key difference is the level of involvement and decision-making by fund managers and investors. Active management relies on expertise and judgment to actively select and adjust investments, while passive management adheres to a predetermined index, requiring minimal ongoing decision-making. Investors may choose between these strategies based on their risk tolerance, investment goals, and beliefs about market efficiency.

Benefits of portfolio construction and management

The need for building a diversified portfolio arises from the inherent goal of investors to optimise returns while mitigating risks. By combining different assets, portfolio management allows investors to align their financial objectives with their risk tolerance.

The construction and maintenance of a well-diversified portfolio provide a crucial means to spread risk across various assets, sectors and industries, reducing vulnerability to the underperformance of any single investment or trade.

In addition, portfolio management involves ongoing monitoring, assessment, and adaptation, enabling investors to respond to changing market conditions, economic shifts, and personal circumstances. By incorporating risk management strategies, optimising costs, and considering tax implications, portfolio management offers a structured and disciplined approach to achieving long-term financial success.

Ultimately, it empowers investors and traders with the tools and insights necessary to navigate the ever-changing landscape of financial markets and work towards their own financial goals.