An Overview of Portfolio Management

Managing a portfolio is all about diversifying your risks without hurting your returns. By putting your money into several different investment vehicles, the risk from individual securities can be dispersed in such a way that your exposure to risk declines. This assumes, of course, that the securities you're buying are sufficiently different in return character- istics . If that's the case, then a security's risk will always be less when held in a portfolio than in isolation. Put another way, while the contribution of a given security to the risk of a portfolio depends on its return behavior traits, it can never be greater than its risk when held in isolation. Thus, from a risk perspective, you can 't go wrong by diversifying your holdings, for it can never increase your exposure to risk. On the other hand, while risk is reduced through portfolio diversification, return is unaffected by this process. The return you earn on a given security is the same whether it's held in isolation or in a portfolio.

To build a portfolio, start with an assessment of your own personal and financial characteristics:

• Your age and experience as an investor

• The size of your family and ages of your children

• The level and stability of your income

• Your net worth

• Your need for income

• Your tolerance for risk

These are the variables that set the tone for your investments. They determine the kinds of investments you should consider and how long you can tie up your money. In order for your portfolio to work, it must be tailored to meet your personal financial needs. Therefore, you must start the portfolio process by taking a thorough inventory of these needs, and repeat this type of inventory every three to five years to make sure your portfolio is staying on the right course.

Once you've done a thorough inventory of your financial needs and have set your sights on one or more investment goals, your portfolio can start taking shape. But before you buy any stocks, bonds, or mutual funds, you must take the time to develop an asset allocation scheme that's right for you. In asset allocation, the idea is to position your assets in such a way that you can protect your portfolio from potentially negative develop -ments in the market, while still taking advantage of potentially positive developments. This is one of the most overlooked yet most important aspects of investing. Indeed, there's overwhelming evidence that, over the long run, the total return on a portfolio is influenced more by its asset allocation plan than by specific security selections.

Generally speaking, most professional money managers view portfolio construction (and/or revision) as taking place in stages:

Asset Allocation

• It all starts with asset allocation!

• Divide the portfolio into major asset classes--how much in stocks, bonds, etc.

• Select groups/types of securities to hold within each major class -- e.g., the mix of corporates and Treasuries within the bond class.

Security Selection

• Last stage/step deals with selection of actual securities to include in each asset class/sub-group--i.e., what specific stocks/bonds you are actually going to invest in.

Basically, all that asset allocation involves is a decision on how to divide your portfolio among different types of securities. What portion of your portfolio is going to be devoted to short-term securities, longer bonds and/or bond funds, and common stocks and/or equity funds? In asset allocation, emphasis is placed on preservation of capital. The idea is to position your assets in such a way that you can protect your portfolio from potentially negative developments in the market, while still taking advantage of potentially positive developments. Asset allocation is one of the most overlooked, yet most important aspects of investing. Indeed, there's overwhelming evidence that, over the long run, the total return on a portfolio is influenced more by its asset allocation plan than by specific security selections.

Asset allocation deals in broad categories and does not tell you which individual securities to buy or sell. So all you're really doing is deciding how to cut up the pie, and then, which particular securities to invest in.

Security selection and portfolio management are recurring activities that become an almost routine part of your investment program. You receive an interest or dividend check, and you have to find a place to put it; you add new capital to your investment program, or one of the Treasury notes you're holding matures, and you have to decide what to do with the money. These events occur with considerable regularity, so you're likely to be faced with a series of little (and sometimes not so little) investment decisions over time.

This, in short, is portfolio management: the initial construction and ongoing administration of a collection of securities and investments.

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