## Scoring Techniques

In portfolio management, the scoring techniques are used for arriving at precise investment needs, in order to enhance the profitability and assistance in numerous strategic planning. This specific technique is not able to optimize things during mixed project scenario and involves little stress on the financial measures.

Scoring Methods

There are two commonly used methods of Scoring including Simple Additive Weighting (SAW) and Weight Product Method.

It is considered to be the best know method that is most widely used technique in portfolio management. It employs regular arithmetical operations including multiplication and addition. In this method, the attribute values are both numerical and comparable.

Weight Product Method

This method does not involve transformation when we multiplication is used among attribute values. The weights turn out to be exponents linked with each attribute value. It assigns negative power for cost attributes and positive power for benefit attributes.

Steps for deriving Scores and weights

The process of deriving weights and scores can be summarised as mentioned below.

· Identifying the applicable non-monetary attributes

· Weight the attributes for reflecting their comparative importance

· Scoring the alternatives for reflecting how each option performs against each attribute

· Calculation of the weighted scores

· Testing the results for accuracy

· Interpretation of the obtained results

Benefits of scoring techniques

Scoring techniques signify an improvement over traditional ratio analysis that is dependent on the remote use of certain ratios. By using scoring techniques, the problem of the attaching relative importance to each ratio is solved as each is weighted based on its ability.

Drawbacks of Scoring techniques

Along with various benefits, the scoring techniques also have various shortcomings. In a scoring equation, the statistical underpinnings may give rise to certain weaknesses. It is imperative to have a sufficient large sample, accurate database and consistent long period in order to reveal trends in the company’s behaviour and measuring its impact.

Features of Scoring Techniques

· The scoring equation is usually based on historical data from recent past and requires to be updated over time. The same equation cannot be used many years later when there is considerable change in financial environment in which companies operate. It is thus imperative for scoring equations to remain updated.

· The scoring equations are designed for measuring the risk of failure for small and medium-sized companies. However, these equations do not serve other purposes like they do not predict about the profitability of the companies in advance. Moreover, they do not measure the risk of failure for big groups. Scoring equations can only be used for companies whose size and business activities are at par with those included in the original sample.

· Scoring technique is the simple and quick way of synthesising figures and these techniques exhibit considerable appeal. The development of scoring methods may lead to mean self-fulfilling effects. The scoring techniques are aimed at providing prior knowledge of the risks of failure. It assists the companies to take required preventive measures.

## Visual or Mapping Techniques

There are many graphing and charting techniques that are employed for depicting the “balance” of a portfolio of projects by showing the performance of various projects on two or more criteria or dimensions. The portfolio mapping diagram which displays project risk and reward is the most widely used and highly popular. It displays probability of success on y axis and reward on X axis. The projects are usually plotted on the diagram as per their approximate success probabilities and payoffs.

Bubble Diagram

A bubble diagram represents a famous variant of portfolio mapping that employs a circle or ellipse for identification of every project in place of a single point. The extra information related to the analogous project is provided by varying the shape, size, colour or shading of the circle. For instance, the shape of the circle may be used for representing the initial costs of the project.

The risk-reward portfolio mapping involves keeping the projects into various categories as per the quadrant they fall into. It is followed by labelling of the 4 quadrants of the diagram as shown below.

· Pearls: They have high probability of success and generate high payoffs

· Oysters: They are long shots, but with high payoffs

· Bread & Butter: They are low-risk projects with low rewards

· White Elephants: They are low probability and low payoff projects

Portfolio mapping tools acts as useful devices for displaying the attributes of projects, however they do not offer basis for making decisions regarding how to trade off those attributes. Moreover, they do not tell what balance among the various attributes is best for the project portfolio.

Portfolio Planning Matrix

The portfolio planning matrix is the graphical tool used by large companies for analyzing and managing their portfolios of SBUs (strategic business units). The company’s SBU’s are located within the cells of the matrix in this tool. The results assist the companies in making decisions regarding the investments to be received by SBU’s. It also assists in identification of the businesses that should be leftover and addition of new businesses to the portfolio.

The portfolio planning matrix is also called as BCG Growth-Share Matrix. It was developed by the Boston Consulting Group (BCG) in the 1970’s. This version represents four quadrants of the matrix that representing low versus high opportunities for growth and low versus high levels of market share.

In this tool, the identification and placement of company’s SBU’s in the matrix is done as mentioned below.

· Cash Cows : Mature SBU’s that yield excess cash due to their dominant market shares in slow-growth markets are kept in the lower left quadrant. These are labelled as Cash Cows.

· Stars : Mature SBUs that eat up cash and have good potential due to their high shares of high-growth markets are kept in the upper right quadrant. These are labelled as Stars.

· Question Marks: SBU’s that needs cash to stay workable and have low shares of high-growth markets are kept in the upper right cell. They are labelled as question marks.

· Dogs : SBU’s that simply yield enough cash to break even and have low shares of low-growth markets are kept in the lower right quadrant. These are labelled as Dogs.

## Portfolio Management Tools

Portfolio management (PM) tools assist the portfolio managers in achieving the optimum balance between attractions and drawbacks, stability and growth, and risks and returns by making the good use of limited resources available. They provide the organized and systematic ways for analyzing the set of projects or activities.

Common Aspects of PM tools

There are certain common aspects of various Portfolio management tools.

· The results obtained by the assessment of individual projects in a portfolio are balanced with PM tools.

· Portfolio Management can be combined with suitable evaluation techniques of single project.

· PM utilizes the results of the analysis (partially or completely) done for evaluating the individual projects when used for selecting or assessing the projects.

· The projects do not occur during the same period of time when PM tools are applied therefore there are some discontinuities.

· One of the main tasks of PM tools is to balancing the projects on time in terms of costs and returns over time.

· In order to ensure the uniformity and validity of the input data, it is imperative to examine every project in a similar way. It is necessary for the balancing of the projects.

Popular Portfolio Management tools

There are many project evaluation tools that can be applied to portfolio evaluation techniques

by making direct comparison of the assessment results of individual projects. In addition to these, there are certain techniques that are designed specifically for PM.

2D and 3D matrices

It is based on the graphical representation of many variables in 2 or 3 dimensional matrices

Variables, important to the decision-maker are preferred

Discussion is encouraged for arriving at the decision

Mathematical programming

It is based on the complex mathematical algorithms

It is targeted at optimization of the portfolio

Requires computer support

This cannot be easily adapted to various companies and conditions as it is company specific

They are used for devising the solution like selection of the projects for investments

Others Tools

Others tools are used primarily for project evaluation such as decision tress and others

2D and 3D matrices

The 2D and 3D matrices are used for the analysis and representation of business units, projects or activities on the basis of 2 or 3 meaningful variables. All these matrices need a similar process for taking decisions and analysing the data. They are considered to be complementary and hence they are grouped together.

The portfolio is analysed by business and RTD managers by examining each individual project. It is followed by placing each project within portfolio matrices that incorporates the strategic elements that are critical to the particular company and its industry.

The2D and 3D matrices techniques are suitable for any company and context and therefore they are very popular and interesting. They are easy to implement and compared with other techniques.

These matrices offer a framework for assessment of various parameters, and company should do some experiments for applying these tools for finding the suitable combinations. These matrices require the judgement and these judgements are supported by using these PM tools.

## Portfolio Management Theory

Modern portfolio theory (MPT) refers to the theory of investment that seeks to maximize the expected return of portfolio at a given level of risk. Similarly it also attempts to diminish risk for a given level of return expected. To achieve this, portfolio manager choose the proportions of different assets in a portfolio carefully. The modern portfolio theory is extensively used for practice in the financial industry, however basic assumptions of this theory has faced certain challenges in fields like behavioral economics.

Modern Portfolio theory (MPT) presents the concept of diversification in investing by using mathematical formulation. It aims to select a collection of investment assets which has lower risk than any individual asset. It can be observed spontaneously as dynamic market conditions cause changes in value of different types of assets in conflicting ways. The prices in the bond market may fall independently from prices in the stocks market, thus there is overall lower risk in a collection of both bond and stocks assets as compared to individual asset. Moreover, the diversification reduces the risk even if cases where assets’ returns are positively correlated.

In technical terms, a Modern Portfolio theory (MPT) represents the return of asset as a normally distributed function or as an elliptically distributed random variable where risk is defined as the standard deviation of return. According to MPT, the return of a portfolio is equivalent to the weighted combination of the assets’ returns because the portfolio is modelled as a weighted combination of assets. MPT aims to reduce the total variance of the return of portfolio by combining various assets whose returns are negatively correlated or not positively correlated. MPT assumes that the markets are competent and investors are logical.

MPT stress the fact that assets in an investment portfolio must not be chosen individually where each asset is selected on the basis of its own merits. Instead, it is important to observe the changes in price of each asset relative to changes in the price of every other asset in the portfolio. Investing in the assets is basically the exchange between risk and expected return. The assets with higher expected returns are usually more risky.

MPT assists in the selection of a portfolio with the maximum possible expected return at a given level of risk. Similarly, MPT assists in the selection of a portfolio with the lowest possible risk at a given amount of expected return. Thus, it is not possible to have a targeted expected return exceeding the highest-returning available security except there is possibility of negative holdings. MPT stresses the diversification and assists the portfolio managers in finding the best possible diversification strategy.

A Portfolio Manager is responsible for building a portfolio of assets such as stocks, bonds and other assets that generates the maximum possible rate of return at the least possible level of risk. The portfolio management involves allocation of funds in various assets to achieve diversification of portfolio that offer maximum return at the lowest possible risk.

## Portfolio Management Strategies

Portfolio Management Strategies refer to the approaches that are applied for the efficient portfolio management in order to generate the highest possible returns at lowest possible risks. There are two basic approaches for portfolio management including Active Portfolio Management Strategy and Passive Portfolio Management Strategy.

Active Portfolio Management Strategy

The Active portfolio management relies on the fact that particular style of analysis or management can generate returns that can beat the market. It involves higher than average costs and it stresses on taking advantage of market inefficiencies. It is implemented by the advices of analysts and managers who analyze and evaluate market for the presence of inefficiencies.

The active management approach of the portfolio management involves the following styles of the stock selection.

Top-down Approach: In this approach, managers observe the market as a whole and decide about the industries and sectors that are expected to perform well in the ongoing economic cycle. After the decision is made on the sectors, the specific stocks are selected on the basis of companies that are expected to perform well in that particular sector.

Bottom-up: In this approach, the market conditions and expected trends are ignored and the evaluations of the companies are based on the strength of their product pipeline, financial statements, or any other criteria. It stresses the fact that strong companies perform well irrespective of the prevailing market or economic conditions.

Passive Portfolio Management Strategy

Passive asset management relies on the fact that markets are efficient and it is not possible to beat the market returns regularly over time and best returns are obtained from the low cost investments kept for the long term.

The passive management approach of the portfolio management involves the following styles of the stock selection.

Efficient market theory: This theory relies on the fact that the information that affects the markets is immediately available and processed by all investors. Thus, such information is always considered in evaluation of the market prices. The portfolio managers who follows this theory, firmly believes that market averages cannot be beaten consistently.

Indexing: According to this theory, the index funds are used for taking the advantages of efficient market theory and for creating a portfolio that impersonate a specific index. The index funds can offer benefits over the actively managed funds because they have lower than average expense ratios and transaction costs.

Apart from Active and Passive Portfolio Management Strategies, there are three more kinds of portfolios including Patient Portfolio, Aggressive Portfolio and Conservative Portfolio.

Patient Portfolio: This type of portfolio involves making investments in well-known stocks. The investors buy and hold stocks for longer periods. In this portfolio, the majority of the stocks represent companies that have classic growth and those expected to generate higher earnings on a regular basis irrespective of financial conditions.

Aggressive Portfolio: This type of portfolio involves making investments in “expensive stocks” that provide good returns and big rewards along with carrying big risks. This portfolio is a collection of stocks of companies of different sizes that are rapidly growing and expected to generate rapid annual earnings growth over the next few years.

Conservative Portfolio: This type of portfolio involves the collection of stocks after carefully observing the market returns, earnings growth and consistent dividend history.

## Portfolio Management Process 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.

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 the every project in the similar fashion for ensuring the validity and consistency of the input data.

Portfolio Management (PM) Techniques

There are various techniques that are used for supporting the portfolio management process:

· Heuristic models

· Scoring techniques

· Visual or mapping techniques

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 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.

The efficient Portfolio Management is ensured by the senior management team of an organization which conduct regular meetings for managing the product pipeline and making decisions related to the product portfolio.

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 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.

· Marketplace fit vs. product line coverage

· Risks vs. profitability

· 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.

## Passive Portfolio Management Strategy

Passive portfolio management strategy refers to the financial investment strategy where an investor makes an investment as per the fixed strategy that doesn’t involve any forecasting. It stresses on minimizing the investing fees and avoiding the unpleasant results of failing to correctly predict the future.

Passive portfolio management strategy employs the most popular method of imitating the performance of a superficially specified index. It is done by retail investors by buying one or more ‘index funds’. An investment portfolio tracks an index and achieves low turnover, very low management fees and good diversification.

The low management fees enable the investor to receive higher returns in comparison to similar fund investments with higher management fees or transaction costs. Passive management is widely used in the equity market and involves tracking of stock market index by index funds. However, it is getting more common in other types of investment including hedge funds, bonds and commodities. There is vast number of market indexes all over the world and different index funds (in thousands) track several of them.

Implementation of Passive portfolio management strategy

An index fund can be implemented by buying securities in the similar proportion as present in the stock market index. Sampling can also be done to implement passive portfolio management strategy.

The sampling involves purchasing each type of stocks from various sectors in the index but do not include some quantity of stocks of every individual stock. Some of the sampling techniques are very advanced and sophisticated that involves purchasing of specific shares that have high probability of good performance.

Those investment managers who run the investment funds and closely follow the index in their managed portfolios; are called as closet trackers. These investment managers offer little value as managers and charge fees for active management. These managers do not actively manage the fund but secretively follows the index.

Index funds refer to the collective investment schemes that utilize passive investment strategies for tracking the performance of a stock market index. Exchange-traded funds track commodity indices and a specific market. These are managed by passive investment strategies rather than active management.

Advantages of passive portfolio management strategy

Passive portfolio management strategy provides various advantages as mentioned below.

· Low cost: Passive investment strategy incurs low costs as compared to active investment counterparts. It provides meaningful and specific incremental advantage. On other hand, an active manager is required to add enough value for beating the cost disadvantage.

· Reduced uncertainty of decision errors: By making investments, investors are exposed to market risks and passive investment strategy reduces the uncertainty of decision errors. In case of active management, the pressure of achieving the returns that beats the market, may lead to the extra risk for making the wrong investments.

· Style consistency: Indexing enables the investors to control their overall allocation by selecting the appropriate indexes.

· Tax efficiency: Indexing is considered as more tax efficient especially in cases of larger-cap indexes that involve less trading and which are fairly stable.

## Heuristic Models

Heuristic Models refers to techniques based on experience for various tasks such as research, problem solving, discovery and learning. Heuristic methods enhance the pace of finding the desirable solution in conditions where the comprehensive search is unfeasible. Heuristics are strategies that use readily accessible information for problem solving in machines and human beings.

Examples of such method include common sense, educated guess, or intuitive judgment.

Heuristic Processing

Heuristic processing employs the usage of judgmental rules called as knowledge structures. These judgmental rules are learned and stored in memory with experience. The heuristic approach provides an economic advantage as it needs least cognitive effort on the recipient’s part.

Heuristic processing is governed by three factors including availability, accessibility, and applicability.

· Availability is the presence of the knowledge structures or heuristics that are stored in memory for futuristic purposes.

· Accessibility of the heuristic refers to the capability of retrieving the memory for use.

· Applicability of the heuristic relies on how relevant are the knowledge structures stored in memory to the judgmental task.

The heuristic information processors comply with messages delivered by experts due to the use of knowledge structures. The information processor agrees with messages endorsed by others without completely processing the semantic content of the message.

Heuristic views avoid the detailed information processing and involves application of simple rules or cognitive heuristics for the purpose of mediating persuasion. The Heuristic model is one of the common techniques deployed in the portfolio management scenarios.

Heuristics in Engineering

A heuristic is basically an experience-based procedure that is applied for help in solving process design problems that vary from operating conditions to size of equipments. Heuristics helps in reducing the time invested in solving problems. There are many procedures available to engineers including Fault tree analysis and Failure mode and effects analysis.

The Failure mode and effects analysis involves evaluating the problems, ranking them in order of importance and recommending solutions by a group of qualified engineers. The procedures of forensic engineering function as an important source of information in order to investigate problems by using the weakest link principle and eliminating the unlikely causes.

Drawback of Heuristic algorithms

The primary objective of applying Heuristic algorithms is that they do not require to be mathematically proven and function well for meeting a given set of requirements. One common drawback in implementing a heuristic method for meeting a requirement is the failure of engineer or designer to comprehend that the present data set may not work well for future requirements.

The current data can be successfully handled by devising an algorithm; however it is mandatory to confirm that the heuristic method is competent of handling future data sets.

It is imperative that the engineer or designer should have thorough understanding of the rules that create the data and develop the algorithm for meeting those requirements rather than addressing the current data sets. In order to estimate the probability of false outcomes while using heuristics, the statistical analysis should be conducted.

## Active Portfolio Management Strategy

Active Portfolio Management Strategy refers to a portfolio management strategy that involves making precise investments for outperforming an investment benchmark index. The portfolio manager that follows the active management strategy exploits the market inefficiencies by buying undervalued securities or by short selling overvalued securities. Any of these procedures can be used alone or in combination.

Active portfolio managers may create less volatility (or risk) than the benchmark index depending on the targets of the specific hedge fund or mutual fund or investment portfolio. The risk reduction is considered as goal of creating an investment return larger than the benchmark. They use large number of factors and strategies for constructing their portfolio.

Strategies for Constructing the Portfolio

· Quantitative measures like price/earnings ratio (P/E ratios) and PEG ratios

· Sector investments that are expected to deliver long-term macroeconomic trends

· Buying stocks of companies that are disliked temporarily

· Selling at a discount of their intrinsic value

· Merger arbitrage

· Short positions

· Option writing

· Asset allocation

Active Portfolio Management Strategy Performance

The performance of an actively-managed investment portfolio relies on the proficiency of the portfolio manager and research staff. There are many mutual funds that are supposed to be actively managed and they stay invested irrespective of market conditions along with only negligible adjustments in allocation over time. In conditions of prolonged market declines, the managers may use hedging strategies. The performance characteristics are different with two groups of active managers.

Benefits of Active Management

· The active portfolio management strategy allows the portfolio managers to select a variety of investments rather than investing in the market as a whole. There may be different kinds of motivations for the investors to follow active management strategy.

· In order to generate profits, the investors consider that some market segments are less efficient than others.

· Portfolio Manager may manage the volatility or risks of market by investing in less-risky and high-quality companies instead of investing in market as a whole.

· Investors may take additional risk for achieving higher-than-market returns.

· Those investments which are not vastly correlated to the market function as portfolio diversifier and decrease the portfolio volatility as a whole.

· Investors may follow a strategy for avoiding certain industries in comparison to the market as a whole.

· Investors that follow actively-managed fund are more aligned for achieving their specific investment goals.

Drawbacks of Active Management

· There are chances of bad investment choices to be made by fund manager

· Fund Manager may follow an unsafe theory for the management of the portfolio

· The costs related to the active management are higher in comparison to passive management in case of lack of frequent trading

· Fund managers should actively evaluate the fund’s prospectus before investing in an actively-managed mutual fund because most of the actively-managed large and mid-cap stock funds fail to beat or outperform their passively managed counterparts.

· Higher transaction costs results due to frequent trading with active fund management strategies that reduces the fund’s return.

· The short-term capital gains due to frequent trading have an unfavourable income tax impact.