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Portfolio Management… Not Investment Management

Richard Croft
July 22, 2013
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Portfolio management is not investment management. That may seem contradictory, but the distinction is important in terms of one’s financial health, And particularly relevant for investors who rely on their portfolio for income.

A portfolio is the end result of a disciplined process that allocates an assortment of financial assets – i.e. equity assets, income assets, cash assets, real estate assets, etc. – into a mixture that best serves specific objectives. Key to optimizing this asset mix is a determination of your risk profile, with the end game being the delivery of returns that are above what you would expect based on the degree of risk being assumed.

Portfolio management concentrates on the management of the collection rather than on the particular investments that make up that collection. Individual securities matter only to the extent that they improve the collection.

That’s very different from investment management, where individual securities are the beginning and the end. Investment management concentrates on individual securities with little regard as to how those securities fit together within a portfolio. It’s like buying bread and ham separately without giving any thought to how the two combined might make a great sandwich, let alone recognize how much a little butter, lettuce, tomatoes and cheese would improve it!

Unlike purchasing grocery items within the context of how they mesh into a meal, plan investors typically buy investments as separate discrete items that have nothing to do with each other. Unfortunately, too many investors buy the equivalent of a loaf of bread and a box of dishwasher soap because the concept of putting things together never crossed their mind.

The portfolio approach gained widespread acceptance in 1952 when an undergraduate student named Harry S. Markowitz challenged conventional wisdom. His thesis debated whether investments should be kept to themselves all the time or whether one could benefit from how securities interacted with each other. Much like an orchestra benefits from the synergies of different musical instruments.

Markowitz discovered that investments not only don’t work in isolation but when combined in a portfolio can actually turn out higher returns with lower risk. His conclusion, which came to be known as modern portfolio theory, opined that a properly constructed portfolio of individual securities creates synergies where the output of the combination is greater than the sum of the parts.

A portfolio then is an intelligently-combined collection of securities which is managed within the context of how well new securities fit with securities already there. The goal is to ascertain what the inclusion of an additional security will add to the portfolio in terms of return and what it will do to the portfolio’s risk.

The logic is appealing, yet most investors never think in terms of synergies. Securities are purchased based on historical returns rather than on what they may or may not bring to the whole.

To be fair, I am not suggesting that investment management is bad. Quite the contrary. If you are looking to buy a good Canadian stock, you should be interested in how that company’s fundamentals stack up against its peer group, and whether the sector in which the stock resides will outperform the broader market. I also accept the tenet that good stock picking will deliver superior results over time.

What I am saying especially for readers of this blog, is that the portfolio should provide for your long term security, leaving the speculative trades on individual stocks to supply the oomph that, in a best case scenario, adds value. In that light, a suggestion to buy calls on say, Canadian banks, should be viewed as an appendage rather than a replacement for your broader portfolio.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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