Portfolio Analysis for Beginners

Understand and Reduce Risk by Analyzing Your Portfolio

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Many new investors are eager to start the process of building their portfolio but often don't realize the importance of designing and implementing a disciplined portfolio strategy, along with an analysis schedule.

It's harder to save and invest money profitably if you aren't prudently overseeing it to improve the odds of having enough growth to harvest the financial rewards you need.

Portfolio analysis can seem daunting until you get the hang of capital allocation. To make the process easier and more accessible, it helps to focus on a few important questions:

  • What is portfolio analysis?
  • Why is portfolio analysis important?
  • What are some of the things to consider when conducting a portfolio analysis?

This basic introduction will better prepare you for the task of assessing your portfolio's health or, if you outsource that job to a professional, understanding some areas about which you might want to ask questions.

What Is Portfolio Analysis?

Properly practiced and implemented, portfolio analysis is the process of breaking down and studying an investment portfolio in order to determine both its appropriateness for a given investor's needs, preferences, and resources, and its probability of meeting the goals and objectives of a given investment mandate, particularly on a risk-adjusted basis and in light of historical asset class performance, inflation and other factors.

The Importance of Analyzing a Portfolio

Say that an investor was to approach a registered investment adviser or asset management company and ask them to provide a portfolio analysis of his or her holdings based upon the investor's need for capital preservation over a period of five years.

The advisory firm would start by looking at the holdings within the portfolio, and it would try to determine if those positions consist of assets that have a high probability of maintaining low volatility, or changes in price, and sufficient liquidity or the ability to turn the investments into cash as needed.

The advisory firm would want to avoid any significant allocation to stocks, preferring instead to emphasize readily-liquid and less volatile options such as cash, well-run money market funds, certificates of deposit that are backed by the FDIC, U.S. Treasury bills and notes, and other comparable investments.

For such a portfolio, the goal of generating investment income in the form of dividends or interest would be a secondary or tertiary consideration after making sure the principal is there when the investor needs to access it and the capital does not sustain any losses.

What to Consider When Performing a Portfolio Analysis

While there are multiple ways to tackle the challenge of portfolio analysis, it helps to separate it into three primary tasks.

First, examine the portfolio on an aggregate basis. The goal is to understand how the portfolio, taken as a whole, is situated relative to other portfolios or some relevant benchmark.

In the case of an all-equity portfolio this might mean looking at the characteristics of a portfolio—total number of portfolio components, the price-to-earnings ratio of the portfolio as a whole, the dividend yield of the portfolio as a whole, the expected growth rate in look-through earnings per share—and comparing them against a stock market index such as the S&P 500 or the Dow Jones Industrial Average.

Second, examine the portfolio components in relation to each other. The goal during this step is to understand how each individual holding within a portfolio is influenced, directly or indirectly, either by each other or by other factors that influence each asset separately. It is important that the portfolio analysis also covers any closely held businesses, such as an investment in a small business, as well as any real estate.

For example, the second-largest Dairy Queen franchisee operator in the United States sought bankruptcy protection in late 2017 because a decline in oil prices had resulted in income losses among the communities where a large percentage of its restaurants were located.

Any investor who held an equity stake in that franchisee operator would have increased his or her risks substantially by holding shares of the oil majors, such as parking stock in ExxonMobil or Chevron in a taxable brokerage account or a Roth IRA.

Even though gasoline, jet fuel, crude oil, and natural gas don't seem to have a lot in common with ice cream cones and hot dogs, they were correlated in this case due to the geographic location of the franchised restaurants, which depended upon local customers who drew their paychecks from the oil majors, to be able to afford dining outside of the home.

Third, examine the portfolio components from the ground-up as stand-alone investments. As each position is analyzed, ask yourself, "Why do I own this?", "What do I expect the after-tax cash flows to be relative to the price I paid?", and "On what terms do I continue to hold the stake?".

This can prevent a lot of folly from making its way onto your personal balance sheet. Additionally, this step is particularly important from a risk-management perspective because it seems as if a certain delusion has overtaken Wall Street and investors from time to time, causing otherwise rational people to get it into their heads that they must own [insert the name of a specific company, sector, or industry doing well at the moment here]. 

With the recent rise of so-called Robo-Advisors, this problem seems to have gotten worse. Upon conducting a portfolio analysis review for a client, a financial advisor might discover that their predetermined asset allocation included a low-cost bond ETF. The problem here is that, after digging into the filings of the exchange-traded fund, the advisor discovered that some of the bonds held by the fund were high-risk junk bonds representing loans to third-world countries.

It is irrational to buy an asset that you don't want simply because it fits some bizarre checklist of things you think you need, without looking into it more deeply. There are many, many ways to build wealth.

It would be less risky to earn a bit less money by holding investment-grade corporate bonds, rather than invest your precious capital halfway around the world into the debt securities of a nation that has a real chance of not being able to pay its bills.

Institutional Portfolio Analysis Is More Complex

While these three steps are likely enough for most individual investors, institutional investors have several other portfolio analysis processes they might want to complete when reviewing assets under management.

Related to the above processes, many portfolio managers prefer to do back-dated stress testing to see how a given portfolio might have been likely to perform under different economic or market conditions by simulating a recurrence of The Great Depression of 1929, the stock market crash of 1987, the 1997 Asian financial crisis, or The Great Recession that began in December of 2007.

At the institutional level, professional service providers such as Bloomberg and FactSet offer services that allow these simulations to be run in near real-time or have them automated according to a schedule for regular portfolio analysis review by the portfolio manager or investment committee of an asset management company.

Additionally, an investment advisory company that has been hired to invest capital held in a pension fund, which is subject to numerous laws and regulations including the Employment Retirement Income Security Act of 1974 (ERISA), is going to want to make sure that the portfolio's holdings are compliant and proper.

The same is true of a trustee of a trust fund, who should regularly ensure that a trust's assets and transactions, including any distributions or payments, are in harmony with the trust instrument.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.