New year - new financial goals: basic portfolio management approaches

We have already talked in detail about what an investment portfolio is and what types of portfolios there are. Read this material to refresh your knowledge (spoiler - there is a lot of text, but also a lot of examples).

Portfolio management is a holistic investment strategy aimed at:

• preserving capital; 
• achieving the highest possible return in the long term; 
• reducing the risk of losing invested funds.

In general, many approaches to asset portfolio management can be divided into active and passive strategies.

The active portfolio management involves careful and constant monitoring of the market, tracking the economic situation. This is done for the immediate acquisition of instruments that meet the objectives of the portfolio, as well as its rapid change. 

The use of this strategy requires significant financial costs for information, analytical and expert analysis.

The passive strategy t involves the formation of a well-diversified portfolio, with a predetermined level of risk, predicted for the long term. This approach is rational only if the market is fairly efficient and saturated with good quality securities. 

With a high level of inflation and unstable market conditions, the passive strategy is ineffective. 

Both strategies include two basic management methods.

Qualitative approach

The essence of this approach is to form an initial idea of ​​the current market situation on the basis of one's own or someone else's experience. 

Thus, you can: 

• follow the news and make decisions to buy or sell assets based on it; 
• use ready-made software tools that allow you to assess the current situation on the market and predict the future situation based on your opinion; 
• ask subject matter experts who have extensive experience in portfolio management, and discuss your point of view with them.

The qualitative approach includes news analysis, peer review, technical analysis or discussion etc. Technical analysis is a very popular decision making tool in portfolio investment. Its main goal is to search for similar patterns in historical data based on a number of indicators (for example, moving averages, fractals, Fibonacci lines, etc.). Technical method is only a graphical analysis and should be used more as an auxiliary tool.

But you need to understand that a qualitative approach cannot always answer the question why an asset should grow or lose in value in the near future, or why one asset has a higher risk than another. The following group of methods will help us answer all these questions.

Quantitative approach

Unlike qualitative methods, quantitative methods make it possible to form a portfolio management strategy based on the figures and models. Roughly speaking, this is the language of indisputable facts. Examples of quantitative management methods include fundamental analysis, comparative analysis, and simulation modeling.

Types of quantitative approaches

Fundamental analysis allows the investor to consider all the factors affecting the price of an asset and, based on numbers, make an appropriate decision. For example, by analyzing the financial statements of a company, we can estimate its real value. If it turns out to be below the market, this is a signal that the company is underestimated, which requires additional analysis of the reasons.

With the help of macroeconomic analysis, we can build forecasts based on fundamental knowledge about the connections between macroeconomic variables. So, for example, if we see that the world is in a cycle of economic recession, then we can begin to gradually sell our assets, or vice versa, start buying more assets on drawdowns, knowing that in the long run they will again rise in value.

Or, using the balance of risk and return, we can estimate the probability of losing our investments. If this level is acceptable for us, we can try to buy a risky asset without losing a significant part of our investments.

Comparative analysis is based on the ability to compare assets according to some quantitative characteristics. The objects of comparison should be similar in certain respects. Companies must belong to the same industry, make similar products. You need to identify common features by which they can be compared, highlight the strengths and weaknesses of each company, and find the main factor for each of them. 

We can compare two or more stocks of companies in terms of P/E or P/S. The P/E ratio (Price/Earnings) actually means the value of the company in years, that is, in how many years the company can fully recoup its cost. The P/S (Price/Sales) ratio means for how many years the total amount of revenue can cover the full cost of the company. These are the two classic and most commonly used benchmarking multiples.

In the case of banks and financial organizations, they usually look at the ratio of capitalization to the property of the company. It can be accurately assessed and used for core business minus all liabilities (P/BV - Price / Book value).

Simulation modeling is the most difficult portfolio management method in terms of implementation and choice of methodology. The methodology may include scenario analysis, mathematical modeling, link analysis and forecasting.

With the help of link analysis and mathematical modeling, we can clearly show the relationship between variables and indicate their influence on each other based on the analysis of historical data. 

Modern analysts mainly use numerical simulation methods based on Monte Carlo or Metropolis-Hastings algorithms. They allow the investor to look at all possible outcomes, their probabilities and help in making an investment decision. However, simulation modeling requires high costs, knowledge, experience and time for calculations.

In conclusion 

Active portfolio management allows you not to miss any details, but at the same time requires a effort and resources. Probably, in some moments, passive management can become a more profitable option, at least because it will not exert psychological pressure due to falling assets and the value of your portfolio.

In general, investment portfolio management does not always involve constant monitoring of charts, news and endless calculations. There are many free services with ready-made analytics that allow you to switch to passive portfolio management with a smaller risk of losing funds. The main question is your financial goals and investment strategies.