Portfolio Analysis: Meaning, Tools, Steps and Objectives


Meaning of Portfolio Analysis

A portfolio is a basket of investments consisting of financial securities like stocks, bonds, mutual funds, etc. 

Portfolio analysis is the process of assessing the risk and return profile of a complete basket to meet the financial goals of the investor.

This is done by market participants including portfolio analysts. These portfolio analysts engage in equity research using fundamental and technical analysis, valuation models, and other metrics. Since no two individuals have common financial needs and risk-bearing capacity, hence there come the portfolio managers who customize the investment based on the background, risk, and return of the clients. Constructing an investment portfolio requires a deliberate and precise portfolio planning process that includes.

Process of Portfolio Analysis

Assessing the current situation

Planning for investments requires analyzing the present scenario of the investor. Knowing the current asset, cash flow, debt, etc to form future strategies to accomplish the stated goal. The portfolio manager needs to understand the values, mindset, and priorities of the investors for developing the appropriate strategy.

Establish Investment objectives

This process involves identifying the risk-return profile of investors. Determining how much risk the investor can take for the required returns for the formulation of the Investment strategy. Secondly, it involves establishing a benchmark to compare the actual portfolio performance and make adjustments a long way.

Determine asset allocation

Following the quote “don’t keep all your eggs in one basket” it is important to diversify the portfolio to minimize the risk and maximize the returns. Exploring various avenues of allocation like cash, stock, bonds, and alternative investments concerning the risk-return profile of the investors. 

Selecting Investment options

The portfolio can be managed in bilateral ways that are active and passive. Active management refers to outperforming the market in comparison to a specific benchmark through more frequent trades whereas passive management mimics the investment holdings of a particular index and requires low shuffling. It is completely on the investors to decide what kind of investment management strategy they want.

Monitor, measure, and rebalance

The portfolio managers monitor the investments (the returns generated, the risk associated, etc), compare them with a specific benchmark, and in case of any differences, rebalance the portfolio by selling the non-performing stocks and buying the stocks with higher potential.

Tools of Portfolio Analysis 

There are numerous tools used to analyze the portfolio of the investor. Some of them are : 

i) Arithmetic Mean: Arithmetic mean is the average of all the variables in the series. It can be used to calculate the average return of the portfolio. 

ii) Sharpe Ratio: Sharpe ratio is the ratio used to calculate excess return above the risk-free rate of return; divided by the volatility of the portfolio. 

For example: Interest on the savings account is 4%, return on stocks is 6% and the standard deviation of the portfolio is 1.25. 

Therefore, (Return on stocks-Savings account interest)/standard deviation

                  = (6-4)/1.25


iii) Alpha: Every portfolio has a benchmark to compare its performance with. 

Alpha calculates the excess or lower return of a portfolio with respect to a benchmark index.

For example, John’s portfolio is yielding him an annual average return of 12%. However, the annual average return of the S&P 500 is 10%. So, John’s portfolio’s alpha is 2%. 

iv) Beta: Beta measures how volatile security is with respect to its benchmark index. Beta lies within the range of -1 to +1. 

If the beta of any security is more than 1, it is less volatile than the market trend. However, if the Beta of any security is more than 1, it is more volatile than the market trend. The standard Beta of the benchmark is considered 1. So, if Apple Inc.’s Beta is 1.3, it is 30% more volatile than its benchmark (S&P 500).

Steps of Portfolio Analysis

For building a standard portfolio, one must follow a set of self-created rules/steps to yield fair returns. To sum it up: 

Define your risk-reward ratio

Before creating a portfolio, the investor must specify his risk appetite and return expectations from the investments he is making. He must, then, buy or sell securities based on the advice of his financial advisor along with personal analysis. 

Choose a Benchmark

Next important step in creating a portfolio is allocating a precise benchmark. Every portfolio must have a standard benchmark to compare its returns. 

If your portfolio’s returns are more than the benchmark index, your portfolio is outperforming. However, if your portfolio is giving you lesser returns than the index, your portfolio is underperforming. 

Analyse the Performance

The last step in portfolio creation and management is evaluating the performance of your portfolio and making required changes in case of any deviation from the pre-defined financial objective.

Objectives of Portfolio Analysis

Different investors have different approaches and objectives aligned with their investment and portfolio management. 

Some investors desire long-term capital appreciation in their lumpsum investment while some may demand regular income from the same. Some investors invest in multiple securities to manage their risk and return while others deploy their funds to ensure optimum utilization of their financial resources. 

Moreover, if people want they can also get their funds managed. There are two ways in which funds are managed: 

Actively Managed Funds

In this, Fund managers actively trade and invest in securities and keep a frequent eye on the movement of prices. They closely examine the deployment of funds, keep rebalancing the portfolio and buy/sell the securities at frequent intervals to yield maximum returns to its investors. 

Passively Managed Funds

In this, Fund managers mainly invest in index funds. Index funds are those funds that invest in benchmark securities and yield similar returns as that of the benchmark. These funds yield decent returns over a period of time.