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Explain the 2-step portfolio construction process and briefly discuss its implications for the investment management industry.

Explain the 2-step portfolio construction process and briefly discuss its implications for the investment management industry.

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Expert Solution

  • here , explains the portfolio construction process and its implications for the investment management industry.

  • Portfolio meaning :

  • Portfolio is termed as a grouping of financial assets such as bonds , stocks , currencies , commodities and other cash equivalents , then mutual , exchange traded and closed funds .

  • it also includes , non publically tradable securities like art , real estate , private investments ..etc.

  • These are directly managed by financial professionals and money managers.

  • Time and risk tolerance are considered when choosing investments to set up a portfolio .

  • Risk tolerance impact on portfolio allocation are as follows :

    A conservative investor will take portfolio with large cap stocks , high grade cash equivalents , broad based market index funds , investment grade bonds...and position in liquid .whether , a risk tolerant investor take small cap stocks to an aggressive , high yield bonds , international and other alternative investing opportunities to built up their portfolio .

  • Time horizon impact in portfolio allocation as follows :

    An investor who saves for retirement , may plans to leave the workforce in during years example , in 5 years .then despite their comfort level investing in stocks and risky securities .then large portion will invest in conservative items such as cash , bonds ..etc., which protect them .

  • In an investor just enter into portfolio making , they will invest mostly in stocks , and take the ability to ride out market's short term volatility .

  • Meaning of portfolio construction is ,

  • Portfolio construction termed as a process of choosing optimum mix of securities needed for the achievement of maximum return by minimum risks.

  • portfolio planning process or construction process :

Step 1 = assessment of current situation.

  • While we takes for future planning , firstly needed to know about investor's current situationin relation to where they want to be .

  • For that purposes, we needs assessment of current assets and liabilities, cash flow and others of investors most important goals .when there is clear defining of goals , it will help to know whether there any gap between current investment strategy and goal.

  • Thus , in first step says that , needs of good discussion about investor's beliefs , values , and other priorities , all which helps to develop investment strategy .

Step 2 = establishing investment objectives .,

  • Here , determining how much risk an investor is takes and how much volatility the investor can with stand , which helps to create portfolio with required return with less risk.
  • When risk and return profile is developed , benchmarks can be established for tracking portfolio performance .

Step 3 = determining asset allocation :

  • With the help of risk return profile , investor can built up asset allocation strategy .thus , investor can allocate as it gives optimum diversification while targeting expected return.

Step 4 = selecting investment options :

  • Each investments are choosing based on parameters of asset allocation strategy .
  • The investment type selected by them is depending upon investor's preference for active or passive management .
  • In an actively managed portfolio , involves individual stocks and also bonds to achieve optimum diversification. Small portfolios can achieve good diversification through mutual funds or exchange traded funds .
  • Passively managed portfolio can be construct with the index funds selecting from different asset classes and economic sectors .

Step 5 = monitor , measure and rebalancing :

  • After implimentation , its management process begins .it including monitoring investments and measuring portfolio performance related to benchmarks .
  • It must , that to report its performance at regular intervals.also review the portfolio plan annually.
  • Review determines , if the allocation is still on target to track the risk return profile .if it is not , it should be rebalanced .

Its implications for investment management industry:

  • Diversification is ne way to reduce risk by allocating in different financial instruments .

  • Its aim is to make maximum return with less risk.

  • Investor faces two type risks as below :

  • 1. Systematic or market risk = this risk is undiversifiable .it is related with every company , which includes inflation rates , political instability , exchange rates , interest rates..etc.they are not specific to a particular company , so not solved through diversification..

  • 2. Unsystematic or diversifiable risk = its specific to a particular company , market or economy .can reduce through diversification. It includes financial risk and business risk .

  • So , you will diversify across the board , not only different types of companies , but also various types of industries .because more uncorrelated your stocks , are the better .

  • Active and passive portfolio management :

    Investors have two choices of investment strategies to generate return on their investment are as follows

  • In active portfolio management focuses on outperforming the market in compare to specific benchmark as Sand P 500 index .

  • Passive management related with particular index to achieve the same result .
  • The main objective of actively managed portfolio , is to beat the market .by taking greater market risk than passive.

  • Passive management portfolio or index fund management , has the purpose of generating return that is the same as the chosen index ..

Thus ,

Portfolio construction means a process of understanding how various financial assets , funds and weightings impacting each other .and also their performance , risk level and decisions which attain the investor's objectives .

And understood its implications for invesment management industry

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