Portfolio Analysis for Beginners
Many new investors are eager to start the process of building their portfolio but don't realize it is important to design and implement a disciplined portfolio analysis schedule.
After all, what good does it do to save and invest money if you aren't prudently overseeing it to improve the odds that it is there when you need to harvest the rewards?
Unfortunately, portfolio analysis can seem daunting until you get the hang of capital allocation. To make the process easier and more accessible, I want to focus on answering several questions for you:
- What is portfolio analysis?
- Why is portfolio analysis important?
- What are some of the things to consider when conducting a portfolio analysis?
My hope is that 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.
Portfolio Analysis and Why It Is Important
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.
To provide an illustration: if an investor were to approach a registered investment adviser or asset management company and ask for a portfolio analysis of his or her holdings based upon a desire for capital preservation over a period of five years, the advisory firm should look at the holdings within the portfolio and try to determine if those positions consist of assets that have what a reasonable person might determine to be a high probability of maintaining low volatility and sufficient liquidity.
The advisory firm would want to avoid any meaningful allocation to stocks, preferring instead to emphasize 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 for making sure the principal is there when the investor needs to access it.
Some Things to Consider When Performing a Portfolio Analysis
While there are multiple ways to tackle the challenge of portfolio analysis, I think it helps to separate it into three primary tasks.
First, examine the portfolio on an aggregate basis. The goal here is to understand how the portfolio, taken as a whole, is situated relative to other portfolios or some relevant benchmark; e.g., 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 other factors that influence each asset separately. It is important that the portfolio analysis include 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 geographic footprint 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—and to repeat something I've said often over the years—you need to 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 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 as the script rarely changes, just the players].
With the recent rise of so-called Robo-Advisors, this problem seems to have gotten worse. Not that long ago, I was conducting a portfolio analysis review for someone and discovered that their predetermined asset allocation included a low-cost bond ETF. The problem: as I dug into the filings of the exchange-traded fund, I discovered that some of the bonds it held were high-risk junk bonds representing loans to third-world countries.
It is profoundly irrational and foolish to buy an asset that you don't like simply because it fits some bizarre checklist of things you think you need. There are many, many ways to build wealth. I'd gladly earn a bit less money by holding investment-grade corporate bonds than ship my precious capital halfway around the world to a nation that has a real chance of not being able to pay its bills.
Institutional Portfolio Analysis Can Be Even 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.