Common Faults in Revision

Common Faults in Revision

Portfolio management involves managing a collection of investment assets with the goal of achieving a balance between risk and return. A key part of portfolio management is regularly reviewing and revising the portfolio to ensure it remains aligned with the investor’s goals and objectives. However, there are common faults that investors may make when revising their portfolios.

One common fault is overreacting to short-term market movements. Investors may panic and make changes to their portfolio in response to a sudden market downturn or upswing, without considering the long-term impact of these changes. This can result in buying or selling assets at the wrong time, missing out on potential gains or incurring losses.

Another fault is failing to diversify properly. Investors may have a portfolio that is too concentrated in one asset class or sector, leaving them vulnerable to market fluctuations in that area. A lack of diversification can result in excessive risk, as the portfolio is not spread across a range of investments.

Finally, investors may fail to regularly review and adjust their portfolio over time. As the investment landscape changes, the portfolio may no longer be aligned with the investor’s goals and objectives. A lack of regular review and revision can result in missed opportunities or excessive risk, as the portfolio is not adjusted to reflect changing market conditions or the investor’s evolving needs.

There are various actions of the portfolio managers or investors that obstruct fair revision of the portfolio. The following are common mistakes made that should be avoided.

Forecasting future based on past without analysis.

One may feel comfortable in projecting future results based on the past performance of the security. This is harmful to the portfolio as the past performance does not necessarily indicate the same results in the future. Just because a stock has provided good returns previously does not ascertain the same or better returns in the future. Similarly, seeing that an asset has not performed well in the previous period does not provide a good base to assume that it will not provide returns in the period(s) ahead.

Differences in practice

While organizations keep less patience with a stock and dispose of it when it does not give expected results, experienced individual portfolio managers do not sell securities because the returns are poor in one period. They stay with it if they see promise of better returns in the future periods. Organisation also tends to follow the crowd i.e. they have their managers invest in securities or sell them based on what competing firms are doing rather than do their own assessment and take a judgement call.

Identifying client needs

A portfolio may have to be changed for many reasons. The portfolio manager needs to be attentive and aware of the changes in the requirement of the client. Some important factors affecting the client that lead to a change in the composition of the portfolio are below.

• Change in wealth: In theory, as an investor’s wealth increases or decreases, his or her risk taking capacity also changes along with it. The more wealth a person has, generally the higher risk-tolerance he or she has and vice verse. In reality, the case might be different. While a person’s wealth may have increase, he or she may not want to take risk and lose the newly attained wealth. Hence, contrary to the utility theory, as people get rich they may become conservative and more risk-averse. The fund manager needs to observe these attitude changes in the client toward risk and understand his/her perspective.
• Change in time horizon: Because of the event in a client’s lifecycle, the time horizon of an investment may change. Events such as births, deaths, marriages and divorces have an impact on the time horizon of an investment due to the person’s priorities changing. The portfolio managers are sometimes not sensitive to these changes and they do not alter the portfolio as per the client’s suitable time horizon. This is most likely because the re-composition part involves much work.
• Changes in liquidity needs: In order to keep liquidity in a portfolio, the investor loses out on his or her goal achievement. The portfolio manager is required to increase the weight of liquid investments in the asset mix. Because of this, the amount available for investment in fixed income and/or growth securities that help achieve returns gets reduced.

Asset mix rebalancing

An asset mix that has been form after much deliberation, tends to drift away gradually due to day-to-to changes in stocks. There are two reactions to this shift. One is regarding it a value added, the other seeing it as precluding a profitable switch among assets. But investors tend to ignore this shift and do not take the precautionary measures to control a drifting mix.

Excess cash

Cash reserves may not necessarily aid an investor. It can be highly risky investment. This is because if the interest rate falls, then the income on cash investment will also fall, and the opportunity for long-term investors gets sacrificed. Cash may be a good source for short-term investments

Using stock screening models

Managers frequently use stock screening models that include rebalancing activities. Some of these models have added considerable value over time, but they are not without drawbacks. The transaction cost is ignored. Screening models do not include such costs in their return equations and further it seems to favor the smaller stocks as compared to bigger ones. Because smaller stocks are more in number, the selection of smaller stocks would be more than warranted by their share of aggregate equity market value.

While changing the investment mix to suit changes of the client, it must be communicated to the client that the investment mix may result in an overall reduction in return or a higher risk may have to be borne for the same return as the universe of available investment opportunities has undergone a change.

 

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