As a new investor, you may be eager to start building a portfolio. Regular portfolio analysis is vital to your success.
It's harder to save and invest profitably if you don't check in on your money. Analyzing your portfolio improves the odds of having enough growth to harvest the financial rewards you need down the road.
This can seem daunting until you get the hang of capital allocation. This basic introduction will better prepare you for the task of assessing your portfolio's health. If you outsource that job to a professional, you'll learn the questions to ask.
- The first step in portfolio analysis is learning how assets tend to perform. That's so you know how adding or reducing a given asset will affect the total portfolio performance.
- It helps to review several levels. Make an overall review, an asset-to-asset comparison, and an individual review of each asset.
- Be sure to review regularly to ensure the holdings still fit your goals and investment style.
- You may also want to look at how your assets performed in a crisis to stress-test the portfolio for surprise downturns.
What Is Portfolio Analysis?
Portfolio analysis is the process of studying an investment portfolio to see if it meets a given investor's needs, preferences, and resources. It also measures how likely it is of meeting the goals and objectives of a given investment mandate. This is done on a risk-adjusted basis, looking at factors such as how the asset class performed in the past, as well as inflation.
How Portfolio Analysis Works
To analyze a portfolio, you need know the types of assets and their characteristics.
For instance, you may ask a registered investment advisor or asset management company to review your portfolio knowing you need to preserve capital for five years.
For that mandate, first, the firm would look at your holdings to assess if they are likely to hold their price, and are liquid enough to cash in as needed.
The advisory firm, in this case, would want to avoid any major stake in stocks, due to their likelihood of price changes. Instead, they'd focus on liquid and less volatile options such as cash, money market funds, certificates of deposit (CDs), U.S. Treasury bills and notes, and other investments of this type.
For this portfolio, the primary goal is to ensure the principal is there when you need to access it. You want the capital to hold its value. Earning income in the form of dividends or interest are less important here.
The goal of your portfolio is unique to your situation. So an analysis will change accordingly. To analyze a portfolio, it helps to break the process down into three steps.
How Your Portfolio Performs as a Whole
First, study the portfolio as a whole. The goal is to know how the portfolio is situated relative to other portfolios or a relevant benchmark.
In the case of an all-equity portfolio, this might mean looking at the total number of portfolio components. That's the price-to-earnings ratio of the portfolio as a whole, its dividend yield as a whole, and the expected growth rate in look-through earnings per share. Then, compare these against a stock market index such as the S&P 500 or the Dow Jones Industrial Average.
How Your Assets Relate to Each Other
The second step is to examine the portfolio components in relation to each other. The goal of this step is to learn how each holding within a portfolio is influenced, directly or indirectly, by the others. You're also looking at how other factors influence each asset separately.
For example, look at the second-largest Dairy Queen franchise operator in the United States, Vasari LLC. In October 2017, it announced it was seeking bankruptcy protection. A decline in oil prices had led to income losses among the communities where many of its restaurants were located. This resulted in the firm closing dozens of sites, mostly in Texas.
Any investor who held an equity stake in that franchisee operator would have greatly increased risks if they also held shares of the largest oil firms (so-called oil majors). This could be stock parked 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 linked in this case because of the region of the franchised Dairy Queens.
These franchises depended upon local customers who drew their paychecks from the oil companies. Thus, when oil did badly, those Dairy Queens did, too.
How Your Assets Perform Alone
Your third task is to review the portfolio components as stand-alone investments. As you analyze each, ask yourself:
- Why do I own this?
- What do I expect the after-tax cash flows to be, relative to the price I paid?
- On what terms do I keep holding the stake?
This can prevent a lot of folly from making its way onto your balance sheet. This step is also very important for risk management. From time to time, Wall Street and investors get caught up in an irrational wave. They get it into their heads they must own a certain company, sector, or industry that's hot at the moment.
A financial advisor might review a portfolio and find that the investor's predetermined asset allocation includes a low-cost bond exchange-traded fund (ETF). The problem here is that, after digging into the filings of the ETF, the advisor discovers some of the bonds held by the fund are high-risk junk bonds for loans to third-world countries.
In such a case, it would be less risky to earn a bit less money by holding investment-grade corporate bonds. It's safer than sending 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
Institutional investors can perform several other portfolio analysis processes when evaluating assets under management.
For example, many portfolio managers prefer to do back-dated stress testing to see how a given portfolio might have been likely to perform in varied economic or market conditions. They may simulate a recurrence of the Great Depression, 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 products that let these simulations be run in near real-time. Another option is to automate them on a schedule set by the portfolio manager or investment committee of an asset management firm.
An investment advisory company hired to invest capital held in a pension fund will want to ensure the portfolio's holdings are compliant and proper. Pensions are subject to numerous laws and regulations, such as the Employment Retirement Income Security Act of 1974 (ERISA).
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 keeping with the trust instrument.