Portfolio Management Process – Steps | Investment Policy Statement | Asset Allocation

Table of Contents

1. What are the Steps in the Portfolio Management Process?
2. Why the Asset Allocation Decision Matters Most
3. The Investment Policy Statement
4. Investment Constraints
5. Reading the Investor: Psychographics and Life Cycle
6. Benchmarking the Client’s Portfolio
7. Strategic versus Tactical Asset Allocation
8. Rebalancing
9. Frequently Asked Questions

1. What are the Steps in the Portfolio Management Process?

There are four, and they run in sequence.

1. Develop the policy statement. This is the road map. It identifies the investor’s risk appetite and defines investment objectives, goals and constraints.
2. Study current financial conditions and forecast future trends.
3. Construct the portfolio, taking both the policy statement and the market forecast into account.
4. Measure and evaluate performance.

Grouped differently, the same four steps are planning, execution and feedback. The process is a loop rather than a line: investor needs and market forecasts are both dynamic, so the portfolio has to be monitored continuously and rebalanced from time to time.

2. Why the Asset Allocation Decision Matters Most

Asset allocation is the process of deciding how to distribute an investor’s wealth across asset classes. An asset class is a collection of securities sharing similar characteristics, attributes and risk and return relationships. Bonds, equities and cash-like securities are asset classes. Each divides further: bonds into treasury, corporate and junk; equity into large cap, mid cap and small cap.

Asset allocation is considered the most important investment decision, because it is the major determinant of risk and return for a given portfolio. The support for that is empirical. Brinson, Hood and Beebower concluded in 1986 that a portfolio’s target asset allocation explained the majority of a broadly diversified portfolio’s return variability over time. Ibbotson and Kaplan confirmed the finding in 2000. Across all portfolios, the asset allocation decision explains an average of 40 per cent of the variation in fund returns. For a single fund, it explains 90 per cent of that fund’s variation in returns over time.

Correlation is what makes the allocation work. It measures the strength and direction of the relationship between two variables and ranges from minus one to plus one. Assets inside the same class are sensitive to the same economic and investment factors, so correlation within a class tends to be high and correlation across classes tends to be low. That relationship holds when the economy and the industry are stable. It does not hold under distress: during the COVID-19 pandemic, fear and uncertainty pushed all asset classes in the same direction until normalcy returned.

Correlations also change with time and with the economic regime. Past correlation is a starting point for the allocation decision and not a substitute for judgement about the future.

3. The Investment Policy Statement

Development of the Investment Policy Statement is the key step in the portfolio management process. It is drafted by the investor or the adviser, and it specifies investment objectives, goals, constraints, preferences and the risks the investor is willing to take. Every investment decision is taken against it. Because an investor’s requirements change, the IPS has to be revised periodically.

3.1 What an IPS is for

It serves four purposes:

• It enables the investor to hold a realistic return expectation
• It enables the portfolio manager to make effective investment decisions
• It provides a framework against which the portfolio manager is evaluated
• It protects the investor against inappropriate investment decisions or unethical behaviour by the manager

Preparing one builds a disciplined system into the management of investments and cuts down the chance of an inappropriate decision.

3.2 Risk profiling before investment

Under the SEBI PMS Regulations, a PMS provider must carry out risk profiling for an investor before undertaking investments. The workbook sets out six of the questions that profiling must incorporate:

• Investment experience in securities
• The indicative percentage of the total investment portfolio proposed to be invested with the portfolio manager, which is optional
• Overall investment goals: capital appreciation, capital appreciation with regular income, or regular income
• Risk tolerance, stated as low, medium or high
• The period for which investments are proposed to be made, which has to match the term of the agreement
• Provisions for systematic withdrawal, monthly, quarterly or annual

Accurate answers matter here in a way clients do not always appreciate. The profile drives the allocation, and an investor who overstates their risk tolerance in a questionnaire has misdirected their own portfolio.

3.3 Investment objectives

Objectives are identified in relation to risk, return and liquidity. Risk is the variability in expected returns. Return is the amount generated over and above the initial investment, expressed as a percentage per annum. Liquidity is the ability to convert an investment into cash when required, without much delay and without loss of value.

An objective can be stated in absolute terms, such as generating 15 per cent a year for a stated number of years, or in relative terms, such as generating 5 per cent a year more than the NIFTY 50. Investors generally invest for preservation of capital, regular income and capital appreciation. Tax saving sometimes enters the picture, though it is not regarded as a sound sole motive for investing.

The objective drives the allocation directly. Capital appreciation points to equity and to the higher risk that comes with it. Capital preservation tilts the portfolio towards safe bonds and debt securities. Regular income points to dividend-paying stocks, interest-paying bonds and rent-yielding property.

4. Investment Constraints

Constraints are the limits on an investor’s ability to take exposure to particular opportunities. They cover liquidity needs, time horizon, and other unique needs and preferences. Five are set out in the workbook.

The Liberalised Remittance Scheme figure is worth committing to memory. It applies to all resident individuals, including minors, for the financial year running April to March, and covers permissible current account transactions, capital account transactions or a combination of the two. The scheme was introduced on 4 February 2004 with a limit of USD 25,000, and the limit has been revised in stages since.

Beyond these five, an IPS may also record reporting requirements, the rebalancing schedule, the frequency of performance communication, and the investment strategy and style.

Where a constraint turns on the current text of a regulation or a circular, the position can be checked against the source on Taxmann.com | Research, and a question about how two provisions interact can be put to Taxmann AI.

5. Reading the Investor: Psychographics and Life Cycle

Two frameworks in the workbook do the work that a risk questionnaire alone cannot.

5.1 The Bailard, Biehl and Kaiser classification

Psychographic analysis sits between standard finance, which treats investors as rational, and behavioural finance, which treats them as normal people who carry biases and make cognitive errors. The Bailard, Biehl and Kaiser framework classifies personality on two axes: level of confidence, running from confident to anxious, and method of action, running from careful to impetuous. Five types follow.

Type is not fixed. A guardian on a winning streak can behave like an adventurer for a while, and most investors turn guardian shortly after a volatile event. Each of the five needs a different approach from the manager.

5.2 The four phases of the investing life cycle

Accumulation. Net worth is small against liabilities and investments are few and undiversified. Goals include children’s education and a house. The time horizon is long and income is growing, so high-return, high-risk capital gain investments are available.

Consolidation. The mid-to-late career stage, where income exceeds expenses. Retirement is still 15 or 20 years away, but capital preservation begins to matter and high capital gain investments are balanced against lower-risk assets.

Spending. Living expenses come from accumulated assets rather than earned income, so stability dominates and dividend, interest and rental income are preferred. The horizon may still run beyond 15 or 20 years, so part of the portfolio should keep growth and inflation-hedge potential.

Gifting. The investor has more assets than they will need. The purpose of the investment changes, towards legacy or a charitable cause.

The boundaries between the phases are not sharp.

6. Benchmarking the Client’s Portfolio

The IPS must provide a framework for evaluating the portfolio, and that normally means a benchmark portfolio matching the composition of the investor’s own. Large cap equity is measured against the BSE 30 or the NIFTY 50. Long-term bonds are measured against a bond index of similar maturity and credit profile. The principle is to compare like with like.

On top of that sits a statutory framework. The SEBI circular of December 2022 on performance benchmarking and reporting of performance by portfolio managers requires an additional layer above the investment approach: broadly defined investment themes called strategies. There are four of them, equity, debt, hybrid and multi-asset, and each investment approach is tagged to one and only one strategy, at the portfolio manager’s discretion.

The Association of Portfolio Managers in India prescribes a maximum of three benchmarks for each strategy, reflecting the core philosophy of that strategy. The portfolio manager selects one of them when tagging an investment approach, so that the investor can judge relative performance. Ensuring the strategy and benchmark are appropriately selected for each investment approach is the responsibility of the portfolio manager’s board.

Re-tagging is deliberately expensive. Once an investment approach is tagged to a strategy or a benchmark, the tagging can be changed only after subscribers have been offered the option to exit without any exit load. The performance track record of that investment approach for the period before the change cannot be used for performance reporting afterwards. The change has to be recorded with proper justification and is verified as part of the annual audit under Regulation 30 of the SEBI (Portfolio Managers) Regulations, 2020.

What that means in practice is that a manager cannot quietly move to a friendlier benchmark and carry the old numbers across. How the resulting performance is then measured and reported is covered in portfolio performance evaluation.

7. Strategic versus Tactical Asset Allocation

Strategic asset allocation is the allocation decision arrived at after considering the investor’s characteristics. It is the target policy portfolio, the translation of the Investment Policy Statement into asset weights, and it is a long-term decision built to meet the investor’s goals over time.

Tactical asset allocation is the short-term component. Decisions are taken more frequently, and the purpose is to take advantage of opportunities in the market. When conditions favour one asset class over another, the manager may temporarily shift money to exploit the discrepancy. A manager who believes equities are overvalued and due a correction, while debt is undervalued, reduces the equity proportion and raises the debt proportion. Once the gains are booked, the portfolio is rebalanced back towards the target allocation.

The distinction is not academic. Tactical allocation attempts to beat the market, and a distributor explaining a portfolio to a client should be able to say which of the two produced a given deviation from the target weights.

8. Rebalancing

A portfolio drifts. Asset classes produce different returns over time, and that changes the allocation away from the target. Rebalancing restores the original risk and return characteristics. It is also triggered by a change in the investor’s own goals, objectives or risk tolerance.

The IPS should carry a rebalancing policy answering two questions: how often, and how much. In other words, the periodicity of rebalancing and the tolerance for deviation from the target policy portfolio.

The decision is a trade-off between the cost of rebalancing and the cost of not rebalancing. If the target allocation is optimal, any drift away from it is undesirable, but restoring it is not free. Two costs arise:

• Transaction cost, the time and money spent on research, brokerage and the mechanics of buying and selling
• Tax cost, since rebalancing normally means selling the appreciated asset and buying the depreciated one, which attracts a liability

Liquidity decides how hard this is. Listed equities and government bonds rebalance easily. Private equity and real estate carry higher transaction costs and are correspondingly harder to move.

9. Frequently Asked Questions

What are the four steps in the portfolio management process?

Develop the policy statement, study current financial conditions and forecast future trends, construct the portfolio, and then measure and evaluate performance. The same sequence is described as planning, execution and feedback.

What is an Investment Policy Statement?

The road map that guides the investment process. It records the investor’s objectives, goals, constraints, preferences and the risks they are willing to take, and it forms the basis for strategic asset allocation. It has to be revised as the investor’s requirements change.

How much of portfolio return does asset allocation explain?

Across all portfolios, the asset allocation decision explains an average of 40 per cent of the variation in fund returns. For a single fund, it explains 90 per cent of that fund’s variation in returns over time.

What is the difference between strategic and tactical asset allocation?

Strategic asset allocation is the long-term target policy portfolio derived from the investor’s characteristics. Tactical asset allocation is a short-term shift made to exploit a market opportunity. Strategic allocation is time in the market; tactical allocation is timing the market.

How many benchmarks can a PMS strategy have?

APMI prescribes a maximum of three benchmarks for each of the four strategies, and the portfolio manager selects one of them for each investment approach.

Can a portfolio manager change the benchmark of an investment approach?

Yes, but only after offering subscribers the option to exit without any exit load. The prior performance track record of that investment approach cannot be used for reporting after the change, and the change is verified in the annual audit under Regulation 30 of the SEBI (Portfolio Managers) Regulations, 2020.

How much can a resident individual invest overseas?

Up to USD 2,50,000 per financial year under the Reserve Bank of India’s Liberalised Remittance Scheme. The limit applies to all resident individuals, including minors.

Law stated as on 10 September 2026. The SEBI (Portfolio Managers) Regulations, 2020 and the circulars issued under them are stated as amended to that date.