A portfolio analysis is a useful tool in evaluating how your investment portfolio is performing in terms of rate of return and risk. Accomplished by looking not only at how your individual investments perform but also how they perform together, an analysis can identify underperforming or excessively risky assets and provide guidance as to where changes to your investment allocations should be made to keep you on track to meet your investment objectives. Although each individual investor has his own goals in terms of performance, a routine analysis can be useful for any portfolio regardless of its strategy. Portfolio analysis is a helpful tool, but it is not without limitations.
Portfolio Analysis Basics
In his book "Portfolio Selection: Efficient Diversification of Investments," author Harry Markowitz identifies the basis of portfolio analysis in two objectives shared by all investors. They want the return to be high and they want this return to be dependable, stable and not subject to uncertainty. This has been interpreted as the trade off between risk and reward. Investors are willing to take risk, but not any more than is justified by the potential return. While maximizing returns is one objective investors can have, portfolio analysis also has advantages in minimizing risk as well as tax efficiency.
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Risk and Return Advantages
Markowitz' Modern Portfolio Theory and views on portfolio analysis, which would eventually earn him in 1990 the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, are focused on evaluating and managing the risks and returns of a portfolio of investments. Through analysis, under-performing assets as well as assets with excess risk relative to their returns can be identified and replaced. This is highly advantageous as the resulting "optimized" portfolio will have either the same expected return with less risk than before or a higher expected return with the same level of risk.
In addition to maximizing returns for a given level of risk, portfolio analysis also is advantageous in minimizing the tax impact on portfolio returns. Depending on such variables as the type of account, security type and tax bracket of the investor, taxation can eat into returns and make otherwise attractive investments mediocre at best. A portfolio analysis with a focus on tax efficiency may prove advantageous in identifying ways to structure investments to minimize the impact of taxes and increase the net return to the investor.
Even with the most careful planning and portfolio construction, past performance is never a guarantee for future results. Even the most thought out investment strategies can fail given the proper circumstances. Additionally, investment objectives can change over time. For example, from long-term growth during the early stages of a career to preservation of capital during retirement, a portfolio analysis will need to be done periodically to make sure your investments are in line with your objectives.