Portfolio Planning

The process of strategizing the construction of an investment portfolio

What is Portfolio Planning?

Portfolio planning is the process of strategizing the construction of an investment portfolio. The investment portfolio should be encompassing of the investor’s risk tolerance, investment time horizon, and expected return of the portfolio.

 

Portfolio Planning

 

Summary

  • Portfolio planning is the process of strategizing the construction of an investment portfolio.
  • Investment managers can develop an understanding of the investor’s risk tolerance through a written investment policy statement.
  • Many investors are restricted in the types of securities they can hold in their portfolio – examples include real estate investment trusts, corporations, and qualified investment accounts.

 

What is the Portfolio Planning Process?

An investment manager is very unlikely to produce a good result for a client without understanding that client’s needs, circumstances, and constraints. For an investment manager to effectively manage a portfolio for a client, they must understand the client’s needs, constraints, and situation. More specifically, the investor’s expected return must be well suited to their risk tolerance. It follows the logic that investors are compensated for the systematic risk taken on.

Investment managers can develop an understanding of the investor’s risk tolerance through a written investment policy statement. The typical aspects addressed by the investment policy statement are:

 

1. Client Description

A brief description of the clients’ investment objectives and individual circumstance

 

2. Purpose

A statement referring to the reason for the investment policy statement

 

3. Duties and Responsibilities

A statement of the distribution of duties and responsibilities among the investment manager, custodian of assets, and the client

 

4. Procedures

Clearly documented procedures to update the investment policy statements and respond to individual circumstance

 

5. Investment Objectives

The client’s expected compensation for taking on market risk

 

6. Investment Constraints

The constraints that the investment is subject to

 

7. Investment Guidelines

Documented guidelines that clearly indicate how the policy becomes executable, restricted asset types, and the leverage taken on

 

8. Evaluation of Performance

The benchmark portfolio for evaluating investment performance and other information on the evaluation of investment results

 

9. Appendices

The appendices must possess information regarding the baseline asset allocation and if any deviations are allowed from the policy portfolio allocation. Moreover, it must also include information on the rebalancing of the portfolio.

 

What are the Potential Investment Constraints?

The investment constraints include the following:

 

1. Liquidity

Liquidity is the ability to convert investment assets into cash rapidly without price discounting. Therefore, liquidity is the trade-off between how quickly an asset can be sold and the price at which the asset is sold.

 

2. Time Horizon

The time horizon is the desired length of investment in terms of time. Generally, the longer the investor’s time horizon, the investor will select more illiquid investment assets. For example, if an investor opts for a short time horizon of one year, the investor will prefer to invest in short-term liquid securities, such as a certificate of deposit.

 

3. Tax Situation

Different investment accounts require separate, distinct tax treatments; therefore, this directly impacts portfolio construction. Assuming an investor is not using a tax-sheltered account, their decision can be impacted by the tax treatment of their investment.

Depending on the investment asset, the investor can be subject to capital gains taxation or income taxation. Some accounts can be tax-sheltered or tax-exempt, and investors tend to invest in securities that generate fully taxable income in these accounts because there is a larger difference in tax advantage relative to more favorable capital gains tax rates.

 

4. Regulatory Constraints

Investors are subject to standard financial market regulations, as well as further specified regulation for certain types of investors. Certain investors are restricted in terms of allowable investments. For example, a few of the investors-facing restrictions are:

 

5. Circumstance

Individual or institutional investors can adopt their own set of preferences regarding the types of assets held. For example, religious or ethical preferences can impact investment choices. ESG factors are becoming increasingly more important for investors. Circumstances surrounding portfolio construction can range from personal preference to macroeconomic conditions.

 

What is Strategic Asset Allocation?

The strategic asset allocation is the percentage allocation of the investment portfolio attributable to a specific asset class. Successful strategic asset allocation is evidenced by two major factors: (1) high correlation between securities of the same asset class and (2) low correlation between asset classes. It allows the investor to mitigate risk with portfolio diversification.

Once the portfolio manager identifies which potential asset classes are suitable to the investor’s risk profile and expected return, the portfolio must identify the correlation of each asset class. Given such information, a portfolio manager can construct an efficient frontier and then identify which portfolio is most aligned with the investor’s risk and return requirements of the investor.

 

Additional Resources

CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Expected Return
  • Investment Policy Statement
  • Fixed Income Portfolio Mandates
  • Investment Horizon

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