Portfolio Management Techniques: Types, Project Portfolio Methods & Drawbacks

Portfolio Management techniques

Portfolio management (PM) techniques are the systematic methods for analyzing or evaluating a set of projects or activities for achieving the optimal balance between stability and growth, risks and returns; and attractions and drawbacks. It focuses on achieving this balance by using the limited resources available in best possible manner.

1. Common aspects of Portfolio management (PM) techniques
• The individual projects are assessed and the results are balanced. Thus, PM involves appropriate single project evaluation techniques for achieving the desired balance.
• It is mandatory to examine every project in the similar fashion for ensuring the validity and consistency of the input data.
2. There are various techniques that are used for supporting the portfolio management process:
• Heuristic models or mathematical model
• Scoring techniques
• Visual or mapping techniques
3. Portfolio Management involves selection of a portfolio of new product development projects for achieving the below mentioned goals:
• Maximizing the profitability
• Maximizing the value of the portfolio
• Providing optimal balance
• Supporting the strategy of the enterprise

Project Portfolio Management Techniques

Project Portfolio Management Techniques comprises of complete spectrum of project portfolio management (PPM) functions. It includes selecting projects and their successful execution by creating project-friendly and formalized environment.

1. The efficient Portfolio Management is ensured by the senior management team of an organization which conducts regular meetings for managing the product pipeline and making decisions related to the product portfolio.
2. Activities of Portfolio management
• Creating a product strategy including products, strategy approach, markets, customers, competitive emphasis, etc
• Understanding the budget or resources available for balancing the portfolio
• Assessment of project for investment requirements, risks, profitability and other suitable factors
• The portfolio management techniques must be used for the proper balance of following goals
• Risk vs. profitability
• New products vs. Improvements
• Strategy fit vs. Reward
• Market vs. Product line
• Long-term vs. short-term

Initially, the Portfolio Management techniques are used for optimizing the financial returns or projects profitability by applying heuristic or mathematical models. However, this approach fails to address the need to balance the portfolio as per the organization’s strategy. Later, scoring techniques came into picture when these are used for weighting and scoring criteria for considering factors such as profitability, risk, investment requirements, and strategic alignment.

The drawbacks of these techniques

The drawbacks of these techniques include inability to optimize the mix of projects and over emphasis on financial measures. Mapping techniques are widely used for visualizing a portfolio’s balance by graphical presentation in the form of a two-dimensional (2 D) graph that displays balance between two factors as mentioned below.

1. Marketplace fit vs. product line coverage
2. Risks vs. profitability
3. Financial return vs. probability of success

The development of new product needs significant investments and Portfolio Management has become widely used tool for making strategic decisions regarding the product development and the investment of company resources. The revenues are based increasingly on new products that are developed during last one to three years. Therefore, the company’s profitability and its continued existence depend on the portfolio decisions.

Two securities portfolios 

If an investor has to invest only two securities, then the risk involve can be easily measured in the terms of standard deviation and co efficient of variation of the expected return of the investment but in the case the portfolio of security having different rate of return to be select then risk perspective of the portfolio is to be analyzed in different way.

Multi securities portfolio 

This can be cover five to ten or hundred assets in the portfolio the basic principle of calculation of expected return variance of the multi securities of portfolio in same as the discuss in case of two security portfolio the expected return of the portfolio is the weighted average of return of individual securities in the portfolio.

Question

	Stock – ABC	Stock - XYZ
Return (%)	11 or 17	20 or 8
Probability	0.5 each	0.5 each
Expected return	14	14
Variance	9	36
Standard Deviation	3	6

1. Expected Return – Return * Probability
• ABC Expected return = 0.5*11 + 0.5 *17
• 5.5 + 8.5 = 14
• XYZ Expected return = 0.5*20 + 0.5 *8
• 10 + 4 = 14
2. Variance = Probability (Return – Expected Return)2
• ABC Variance = 0.5 (11 – 14)2 + 0.5 (17 – 14)2
• 0.5*9 + 0.5*9
• 4.5 +4.5 = 9
• XYZ Variance = 0.5 (20 – 14)2 + 0.5 (8 – 14)2
• 0.5*36 + 0.5*36
• 18 + 18 = 36
3. Standard Deviation = √Variance
• ABC Standard Deviation = √9 = 3
• XYZ Standard Deviation = √36 = 6

Standard deviation 

It is measure of the variance around it’s mean or it is the square root of the sum of the sum of square division from the means divided all the number of observations the arithmetic mean may be same but the return may be varying widely the risk is measured by variance of the rate of return overtime. 

σ = √Variance

Return of Portfolio  R_p=∑(x₁ r₁+x₂ r₂

Where the return of a portfolio is the weighted average of returns of individual securities.

σ_p=√(x₁² σ₁²+x₂² σ₂²+2x₁ x₂ r₁₂ σ₁ σ₂)

Explanation of Symbols

• Rp= Return of portfolio
• x1, x2= Proportion of total portfolio invested in security 1 and security 2
• r1,r2= Expected return of security 1 and security 2
• σp= Standard deviation of portfolio
• σ1,σ2= Standard deviation of stock 1 and stock 2
• r12= Correlation coefficient between security 1 and security 2

Correlation Coefficient (r12)

The correlation coefficient indicates the degree of similarity or dissimilarity in the movement of returns of two securities. It measures how two securities move together relative to their individual risks.

1. The value of correlation lies between –1 and +1.
2. Covariance is not taken as an absolute value (–∞ to +∞), but correlation standardizes it using the standard deviations of individual securities.

Types of Correlation

1. Perfect Negative Correlation (–1): Securities move in opposite directions.
2. Perfect Positive Correlation (+1): Securities move in the same direction.
3. Zero Correlation (0): Security returns are independent of each other; portfolio risk depends only on the individual standard deviations.

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Sandeep Ghatuary

Finance & Accounting blogger simplifying complex topics.

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