First steps in portfolio management

Perhaps you are already familiar with the famous chart from portfolio managers. If not, just do it as soon as possible and then read this first step portfolio management article.

In this section we review the important principles behind the stock selection process that are relevant in the formation and management of the stock portfolios. We focus on the explanation of the principal categories of common stock, especially the investment characteristics that make a category of stock suitable for one portfolio but not for another.

The most widely used categories of stocks are:

  • Blue Chip Stocks
  • Income Stocks
  • Cyclical Stocks
  • Defensive Stocks
  • Growth Stocks
  • Speculative Stocks
  • Penny Stocks

Blue chip stocks

These are the well-known of all the categories of stocks listed above above. Blue stocks are stocks of best known companies in the investment community. It is hard to define this term exactly but one common definition of Blue Chip stock is that the company has long and continuous history of paying out divided to its shareholders. Coca Cola can be quoted as best example as the company has been paying dividends for more than hundred years.

Income stocks

This type stocks are the stocks, where the earnings are largely in the form of dividends, as compared to capital gains. It is considered a dependable, stable investment, conservative, and suitable to supplement your other income. Companies which are well stable and consistent history of paying dividends comes in the category of income stocks.

Cyclical stocks

The value of this type of stocks rise and fall with changes in the business and economy, rising quickly in the period of improving business environment and fall noticeably in the conditions of deteriorating business environment. The examples such stocks could be, construction industry, industrial chemical ,automobile manufacturing, etc.

Defensive stocks OR Protective stocks

These stocks work opposite to cyclical stocks. These stocks change little in prices and are not great interest to speculators. These stocks are categorised as lower risk stocks. The relevant examples of defensive stocks are companies from food sector, tobacco and alcohol, and utilities, cosmetics, drugs, and health care. Such companies has no or least impact on their sales in the time of downward business conditions.

Growth stocks OR Performance stocks

This include the stocks of entities whose existing and predicted earnings are positive to demonstrate an noticeable and steady increase in the value of stock over the extended time period.

Speculative stocks

These are the stocks of new companies with unproven financial status and by companies whose financial strength is below average. Speculation involves a short time span, and the speculative stocks can make investors quick money at the same time there involve high level of risk in such stocks.

Penny stocks

These are low priced stocks and suited for small investors. These stocks has also the ability to generate goof money in short period of time.

The categories of the stocks discussed above are not totally mutually exclusive. Our examples show, some blue chip stocks can be income stock. It is also the case in both cyclical and defensive stocks which can be classified as income stocks in many cases.

Active versus passive portfolio management

There are two types of investment portfolio management approaches:

  • Active portfolio management
  • Passive portfolio management

The main features for the passive portfolio management include:

  • Holding period for longer period with minor changes;
  • Stock Investors act as if the stock markets are relatively efficient.
  • The portfolios, which the investor hold may be substitute for the market portfolio.
  • Perform within the designated benchmarks.

Reason when the investor makes changes in the passive portfolio:

  • Preferences changes of investors;
  • Risk free rate change;
  • Changes in the forecast of risk and returns.

The main points for the active portfolio management:

  • Active investors think there are mispriced stocks or group of stocks from time to time;
  • They believe that the stock markets are not efficient;
  • Active portfolio investor use deviant predictions – their forecast of risk and return change from consensus opinions.