Investment Portfolio Analysis for Beginners

Understand and Reduce Risk by Regularly Evaluating Your Portfolio

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Many new investors are eager to start building their portfolio, but what they may not realize is how important regular portfolio analysis will be to their success.

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

What's more, portfolio analysis 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 or, if you outsource that job to a professional, understanding what questions to ask about your investments.

Key Takeaways

  • The first step in portfolio analysis is learning how assets typically perform so you know how adding or reducing a given asset within your portfolio will affect the overall performance.
  • It helps to review your portfolio on several levels: an overall review, an asset-to-asset comparison, and an individual review of each asset.
  • Investors should regularly review their portfolios to ensure their holdings fit their goals and investment styles.
  • Advanced investors may want to look at how assets performed in previous times of crisis to stress-test their portfolio for unexpected downturns.

What Is Portfolio Analysis?

Portfolio analysis is the process of studying an investment portfolio to determine its appropriateness for a given investor's needs, preferences, and resources. It also evaluates the 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.

How Portfolio Analysis Works

To analyze a portfolio requires knowledge of the different types of assets and their characteristics.

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

To evaluate whether her portfolio could meet that mandate, the firm would start by looking at her holdings to try to determine if those positions consist of assets that are likely to maintain low volatility (changes in price) as well as 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, due to their volatility, and instead emphasize readily liquid and less volatile options such as cash, money market funds, certificates of deposit (CDs), U.S. Treasury bills and notes, and other similar investments.

For her portfolio, the primary goal is to ensure the principal is there when the investor needs to access it and that the capital does not sustain any losses; generating investment income in the form of dividends or interest would be a secondary consideration.

The goal of your portfolio will be specific to your situation, and therefore 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, examine the portfolio as a whole. The goal is to understand how the portfolio is situated relative to other portfolios or some relevant benchmark.

In the case of an all-equity portfolio, this might mean looking at the 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, and the expected growth rate in look-through earnings per share. Then, compare them 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 during this step is to understand how each holding within a portfolio is influenced, directly or indirectly, by the others as well as by other factors that influence each asset separately.

As an example, consider the second-largest Dairy Queen franchise operator in the United States, Vasari LLC, which announced it was seeking bankruptcy protection in October 2017. A decline in oil prices had resulted in income losses among the communities where a large percentage of its restaurants were located, resulting in the firm's closing of dozens of restaurants, mostly in Texas.

Any investor who held an equity stake in that franchisee operator would have increased his or her risks substantially by holding shares of the largest oil companies (so-called oil majors). For example, if he had 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 correlated in this case due to the geographic location of the franchised restaurants.

These franchises depended upon local customers who drew their paychecks from the oil companies; therefore when oil did badly, those Dairy Queens did, too.

How Your Assets Perform Individually

Your third task is to examine the portfolio components as stand-alone investments. As you analyze each position, 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 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 delusion overtakes Wall Street and investors from time to time, causing otherwise rational people to get it into their heads that they must own some specific company, sector, or industry that's doing well at the moment. 

Upon conducting a portfolio analysis review for a client, a financial advisor might discover that the investor's predetermined asset allocation included a low-cost bond exchange-traded fund (ETF). The problem here is that, after digging into the filings of the ETF, the advisor discovered that some of the bonds held by the fund were high-risk junk bonds representing 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, 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 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 under different 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 services that allow these simulations to be run in near real-time. Another possibility is to have them automated according to a schedule by the portfolio manager or the 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.