Whether you’re an active investor or a passive market participant, your actions and decisions fall under the realm of portfolio management.
In general terms, portfolio management is the science of decision-making about how to invest your money. The concept includes strategies and policies for matching investment selection to an individual’s objectives, risk tolerance, and asset allocation requirements. All portfolio management strategies seek to balance risk against performance. Whether you’re investing in equities, bonds or some other type of asset, portfolio management is concerned with determining the strengths and weaknesses of your investment selection methodology to maximize returns relative to your risk appetite.
Although portfolio management strategies vary, they generally fall under four categories:
- Active
- Passive
- Discretionary
- Non-discretionary
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Active Portfolio Management
Active portfolio management requires a high level of expertise about the markets. A fund manager implementing an active strategy primarily aims to generate better market returns than the market. The strategy is ‘active’ in that it requires a constant evaluation of the market to buy assets when they are undervalued and sell them when they exceed the norm. The strategy requires quantitative analysis of the market, broad diversification, and a sound understanding of the business cycle.
The biggest benefit of active strategies is the potential for generating market-beating returns. The strategy also offers flexibility in that the fund manager can adjust their strategy whenever necessary.
On the opposite side of the spectrum, active strategies have notoriously high fees due to constant asset turnover. The impact of human error is also much greater in active strategies.
Active strategies are suited for experienced investors who have a higher risk appetite. These investors are willing to assume greater risk to generate higher returns. Typically, their allocation reflects their desire for market-beating returns, which means a higher concentration of capital allocated to stocks.
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Passive Portfolio Management
Passive portfolio management isn’t concerned with ‘beating the market’ because its proponents subscribe to the efficient market hypothesis. In other words, they believe fundamentals will always be reflected in the value of the underlying asset. Investors who seek to minimize risk often prefer passive strategies. One of the easiest ways to implement a passive strategy is to invest in an index fund that tracks the S&P 500 or some other market index.
Lower cost is the primary benefit of passive investing, as this strategy is probably the cheapest to implement. Passive strategies have also been proven to generate consistently strong long-term gains.
One of the downsides of passive investing is security concentration. For example, if you are tracking the S&P 500, you are overly focused on large-cap equity stocks, which opens you up to risk. Passive strategies are only suitable for long-term investors, so if you need to get your money out, short-term volatility could eat into your gains.
Other disadvantages of passive investment strategies include:
- Opportunity cost as you are giving up the ability to generate market-beating returns
- An inability to protect against downside risk since you are simply tracking the market instead of hedging against volatility
Learn about other portfolio management concepts here.
Discretionary Portfolio Management
A discretionary approach to portfolio management gives the fund manager complete control over their client’s investment decisions. The discretionary manager makes all the buy and sell decisions on behalf of their clients and utilizes whatever strategy they think is best. This type of strategy can only be offered by individuals who have extensive knowledge and experience in investments. Clients who use discretionary managers feel confident in handing over their investment decisions to an expert.
The primary advantage of discretionary investing is that you’re handing over all your investment decisions to an expert. This tends to make life a lot simpler, especially if you agree with your manager’s buy and sell suggestions.
If you enjoy being more hands on with your investments, discretionary accounts probably aren’t for you. If cost is also an issue, discretionary accounts might be more prohibitive since discretionary managers charge higher fees for their services.
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Non-discretionary Portfolio Management
A non-discretionary portfolio manager is essentially a financial adviser. They will give you the pros and cons of investing in a particular market or strategy, but won’t execute it without your permission. This is the primary difference between a non-discretionary approach and a discretionary approach.
The primary benefit of non-discretionary investing is it gives you access to a financial expert without relinquishing control of your investment decisions.
The primary downside comes from the need to quickly shift a portfolio’s focus in the face of new market conditions. If your manager has to get your approval before buying or selling a particular asset, it could cost you.
The Bottom Line
Portfolio management is a critical component of investing. Each portfolio management strategy has a unique set of advantages and disadvantages that need to be weighed before deciding which approach to pursue.
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