Basic principles of effective portfolio management

The two basic principles of effective portfolio management are :

(i)     Invest on the basis of fundamentals of the security.

(ii)     Review and update the portfolio regularly.

The object of the portfolio management is to provide maximum return on the investments by taking only optimum risk. To achieve these objectives, the portfolio manager should invest in diversified securities and see that the coefficient of correlation between these securities is as less as possible (only then the portfolio will be able to reduce the risk). This is the foundation of portfolio management. The portfolio manager should follow the above-mentioned principles to further strengthen his targets of higher returns and optimum risk.

The first principle suggests that investment should be made only in those securities which are fundamentally strong. The strength of a security depends upon three strengths: (a) strength of the company, (b) strength of the industry, and (c) strength of the economy. The strength of the company depends upon various factors like (i) intelligent, dedicated and motivated human resources, (ii) management having positive values and vision, (iii) policy regarding encouraging R&D, (vi) integrity of promoters, and (v) long range planning for profits. The fundamentals of the industry depend upon the product Þ consumer surplus the product provides to its users, various possible alternative uses of the product, and availability (rather we should say non-availability of the substitutes). Economy, here, means national economy. By fundamentals of the economy we mean Þ recession/boom, tax policy, monetary policy, budgetary policies, stability of government, possibility of war and its impact on economy, closed/open economy and finally the government’s attitude towards business houses. The portfolio manager should see that most of the fundamentals are favourably placed.

The second principle suggests that the portfolio should be reviewed continuously and if need be, revised immediately. The Fundamentals of the company, industry and economy keep on changing. Accordingly, the portfolio should be revised according to emerging situations. For example, in case of monsoon failure, investments should move from fertilizer companies to irrigation companies, in case some sick-minded person takes over as CEO of the company, perhaps desired step will be to disinvest the securities of the company, in case cheaper substitutes have emerged for any industry’s product, better move to some other industry, etc.

Two more points regarding the second principle

(i)     Sometimes, after making the investment in some securities, portfolio manager realizes that his decision of investing in that security is wrong, he should not wait for happening of some event which will make his decision as a right one (if there is some loss on that investment, he should not even wait for breakeven); rather he should move immediately liquidate his position in that security. [Remember that no portfolio manager has ever made 100 per cent correct decisions (Warren Buffet is perhaps exception)

(ii)     Do not bother much about transaction cost related to reshuffling of the portfolio, consideration of such small costs generally result in heavy losses or foregone opportunities of earning profit.