NISM Series XXI-A · Chapter 9: Portfolio Management Process

L1 · Foundation

Portfolio Management Process — the ground floor

Why asset allocation matters most, how correlation makes diversification work, the four steps of the process, the Investment Policy Statement, risk profiling, objectives, constraints, SAA vs TAA, factor investing and rebalancing.

14 min read · Worth 15% of the paper · Written from pages 126–142 of the official NISM workbook · Updated 18 September 2026

Start with the mix, not the stock

Most investors spend their energy on one question: which share should I buy? The workbook points somewhere else.

Asset allocation is the process of deciding how to distribute an investor's wealth into different asset classes. An asset class is a collection of securities with similar characteristics, attributes and risk/return relationships — for example bonds, equities, and cash and cash-like securities.

A broad class can be split further:

Broad asset class	Sub-asset classes (workbook examples)
Bonds	Treasury bonds, corporate bonds, junk bonds
Equity	Large cap, mid cap, small cap

Why care? Experience suggests that in the long run, how a portfolio does depends mostly on asset allocation. The choice of mix matters more than people think. And the decision is not isolated. It is one part of the whole portfolio management process.

Correlation — why mixing assets calms a portfolio

Diversification aims to cut portfolio risk. It does this by holding assets that are uncorrelated or negatively correlated. When one asset does badly, another may do well. So the total stays steadier.

The workbook's examples:

Equities and bonds often have low or negative correlation, which makes bonds a hedge during stock market downturns.
Gold and equities typically show negative correlation during economic crises.
Real estate and stocks may have low correlation, adding stability.

Correlation measures the relationship between the price movements of two asset classes. It always lies between −1 and +1:

Value	Name	Meaning
+1	Perfect positive correlation	Assets move in the same direction
0	No correlation	No relationship between movements
−1	Perfect negative correlation	Assets move in opposite directions

Combining assets with low correlation gives better risk-adjusted returns and lower overall volatility.

The four steps of the process

Portfolio management is a set of linked steps. They are done in a logical, orderly and consistent way to build and keep the best portfolio. The elements are planning, execution and feedback.

Develop the Investment Policy Statement (IPS) — the road map. It identifies the investor's risk appetite and defines objectives, goals and constraints.
Study current financial conditions and forecast future trends..
Construct the portfolio, using both the IPS and the market forecast. Because investor needs and forecasts both keep changing, the portfolio needs continuous monitoring and rebalancing.
Measure and evaluate performance..

So the process moves from planning → execution → feedback.

The Investment Policy Statement (IPS)

The IPS is drafted with the investor, not for him. It sets out goals, limits, likes and risk tolerance. All investment decisions are based on it. Needs change, so it must be regularly updated and revised. It is also the base for strategic asset allocation.

Its key purposes, as listed in the workbook:

Helps investors understand their needs and helps portfolio managers build optimal portfolios.
Gives a structured approach, minimising poor decision-making.
Sets realistic return expectations.
Helps portfolio managers make effective decisions.
Provides a performance evaluation framework for portfolio managers.
Protects investors from inappropriate or unethical decisions.

It may also include reporting requirements, rebalancing schedules, frequency of performance communication, and investment strategy and styles.

Risk profiling

Risk profiling helps determine the investor's risk tolerance, investment objectives and financial situation, so the portfolio manager can build a customised strategy. It considers age, financial goals, investment experience, liquidity needs, income stability and psychological risk tolerance.

Keep the five components apart — the exam likes the first two:

Component	What it means
Risk tolerance	The investor's willingness to take risks
Risk capacity	The investor's financial ability to take risks
Investment horizon	The timeframe for goals
Liquidity needs	Requirement for easy access to funds
Investment knowledge & experience	Understanding of financial markets

A questionnaire with a weighted scoring system is used, and profiles need regular review as circumstances change. Other preference questions may cover: the indicative share of the total portfolio to be given to the manager (optional); overall goals (capital appreciation, income, or both); time period of investment — which has to be the same as the term of the agreement; and systematic withdrawal provisions (monthly, quarterly, annual).

Investment objectives

Objectives differ by risk profile, goals, earnings, net worth, experience, age and horizon. The workbook names five:

Capital appreciation — growing wealth, e.g. equities or mutual funds.
Income generation — dividends, interest or rent.
Capital preservation — protecting principal through low-risk instruments such as bonds or fixed deposits.
Liquidity — easy access to funds for short-term needs.
Tax efficiency — optimising post-tax returns.

Investment constraints

Constraints are limits. They stop an investor from taking some kinds of exposure. The causes include cash needs, time horizon and tax. The workbook lists five.

A. Liquidity. Younger people usually need less liquidity than older people. Liquidity needs fall into three groups:

Emergency cash — usually two to three months' spending, more if income is at risk or volatile.
Near-term goals — for known goals due within a year, keep the money in fairly liquid assets.
Investment flexibility — liquidity to grab opportunities when asset classes become over- or undervalued.

Too much cash hurts returns. Too little forces you to sell at a bad time. So write the liquidity needs clearly in the IPS.

B. Regulatory. Individuals usually have few. Two workbook examples: under RBI's Liberalised Remittance Scheme (LRS) a resident individual can invest only up to USD 2,50,000 overseas per financial year (April–March); and insiders cannot trade on information that is not publicly known. The LRS was introduced on 4 February 2004 with a limit of USD 25,000, revised in stages since.

C. Tax. Income (interest, dividend, rent) and capital appreciation are taxed differently, and the same return may be taxed differently depending on the investor's bracket. So understanding of the applicable tax code belongs in the IPS.

D. Exposure limits to sectors, entities and asset classes. Under the SEBI PMS Regulations 2020, the agreement between manager and investor must include the investment approach — a broad outlay of the type of securities and permissible instruments, the type of instruments and the proportion of exposure. Exposure limits avoid concentration risk, and the manager must adhere to them.

E. Unique needs and preferences. Personal, social, ethical or cultural beliefs — say, refusing to hold companies selling environmentally harmful products, or refusing to sell your employer's shares out of emotional attachment. These too go in the IPS.

Goals and the investor's financial position

Investors list goals with priority, time period and amount needed in a goal sheet (Exhibit 9.1). How each kind is usually funded:

Goal type	Typical approach
Near-term, high priority	Cash equivalents or fixed income maturing on the goal date
Long-term, high priority (e.g. retirement corpus)	Diversified across several asset classes
Low priority (farm house, luxury car)	More aggressive approaches

To analyse the financial position, build personal financial statements: a net worth statement (balance sheet) and an income–expense statement. Net worth = assets at estimated market value minus liabilities. Calculate it periodically — at least once a year. The income–expense statement can be prepared monthly and shows what is available to invest.

Forecasting and benchmarking

Portfolio management joins two sets of facts. One is about the investor. The other is market forecasts of risk and return. Past risk and return of each asset class is a good place to start.

The IPS should also provide an evaluation framework, typically a benchmark matching the portfolio's composition — "apple with apple". Large-cap equities → BSE 30 or NIFTY 50. Long-term bonds → a bond index with similar maturity and credit profile.

SEBI's performance benchmarking framework for portfolio managers adds a layer over the investment approach (IA):

Four broad strategies: equity, debt, hybrid, multi-asset.
Each IA is tagged to one and only one strategy, at the manager's discretion.
APMI (Association of Portfolio Managers of India) prescribes a maximum of three benchmarks per strategy; the manager picks one of them.
The manager's Board is responsible for appropriate selection of strategy and benchmark.
Tagging can be changed only after offering subscribers an exit without exit load.
After a change, the IA's earlier track record cannot be used for performance reporting — verified in the annual audit under Regulation 30 of the SEBI (Portfolio Managers) Regulations, 2020.

Strategic vs tactical asset allocation

The asset allocation decision comes from the interaction of the two information sets. The manager chooses the mix that maximises after-tax returns for the investor.

Strategic Asset Allocation (SAA) is long-term. It sets fixed proportions from risk tolerance, return expectations and goals, and periodically rebalances back to them. Features: long-term focus, risk-return optimisation using historical and forecast performance, periodic rebalancing, disciplined investing. Benefits: stability, reduced market timing risk, alignment with goals. Best suited to passive investors.

Tactical Asset Allocation (TAA) is dynamic. Managers actively adjust weights on short-term conditions, allowing temporary deviations within a predefined range. Features: short-term adjustments, active management, enhancing returns, risk management by tilting to defensive assets. It needs market expertise and frequent monitoring, so it suits investors with higher risk appetite and access to professional management.

Factor-based investing

Factor investing selects securities on characteristics expected to drive returns, aiming for better risk-adjusted returns than market-cap-weighted investing. Used in smart beta funds, quantitative and active management.

Two types of factors: macroeconomic (inflation, growth, interest rates, liquidity — affect all asset classes) and style (affect individual securities).

Style factor	Idea
Value	Undervalued stocks (low P/E or P/B) tend to outperform over time
Momentum	Strong past performers tend to keep rising in the short term
Size	Smaller companies tend to beat large caps over the long run
Quality	Strong profits, low debt, stable growth — more resilient in downturns
Low volatility	Lower price swings, historically better risk-adjusted returns

Implementation: single-factor, multi-factor, or smart beta (index-based, but not market-cap weighted). Benefits: risk-adjusted returns, diversification, rule-based discipline, low cost. Risks: factor cyclicality, data and implementation complexity, and overcrowding.

Rebalancing

Rebalancing adjusts the allocation back to the desired mix after markets make it drift.

Why needed: market movements, risk management, investment discipline, financial goals.
Benefits: maintains allocation, enhances returns, reduces risk, encourages buy low, sell high.
Challenges: capital gains tax, transaction costs, market timing, emotional bias.

Weigh the benefits against the costs. The workbook recommends a disciplined approach, periodic reviews and tax-efficient strategies.

Think of it like this

The IPS is the architect's drawing

Nobody in Pune lets a contractor start pouring concrete before the drawing is approved. The drawing records how many rooms the family needs, the budget, the plot limits and the municipal rules. Every later decision — which cement, which tiles — is checked against it.

The Investment Policy Statement does the same job. It is prepared first, with the client, and records needs, constraints and risk tolerance. Every security the manager buys is tested against it. And when the family grows, the drawing is revised — just as the workbook says the IPS must be regularly updated.

Correlation is umbrellas and ice cream

A shopkeeper in Mumbai sells both umbrellas and ice cream. In the monsoon, umbrellas fly off the shelf and ice cream sits. In May, it is the reverse. His total takings stay far steadier than either product alone.

That is negative correlation at work. Two things that move in opposite directions cancel out each other's bad months. If he instead sold umbrellas and raincoats — positive correlation — a dry year would hit both together, and diversifying would do nothing for him.

SAA is the train timetable, TAA is the auto driver

A Rajdhani runs on a fixed timetable. It does not change route because of one traffic jam, and that discipline is why you can plan your life around it. That is Strategic Asset Allocation — fixed proportions, long-term, reset periodically.

An auto driver takes a lane, sees a jam, and cuts through a side road. Sometimes he saves ten minutes; sometimes the side road is worse. That is Tactical Asset Allocation — temporary shifts within a range to grab short-term opportunities. It needs a driver who really knows the city, which is why TAA needs expertise and constant monitoring.

Rebalancing is trimming the hedge

A housing society plans a garden with equal beds of roses and marigolds. By October the marigolds have overgrown and are shading the roses. The gardener cuts the marigolds back and gives the roses more room.

That is rebalancing. The part that grew fastest is trimmed, the part that lagged is topped up, and the garden returns to plan. But every trim costs the gardener's time — just as every rebalance can trigger capital gains tax and transaction costs. So you trim on a schedule, not every morning.

Key terms in this chapter

APMI: Association of Portfolio Managers of India. Prescribes a maximum of three benchmarks for each strategy.
Asset allocation: Deciding how to distribute an investor's wealth across different asset classes such as equity, bonds and cash.
Asset class: A collection of securities with similar characteristics, attributes and risk/return relationships.
Benchmark: An index matching the portfolio's composition, used to judge its relative performance.
Concentration risk: The risk of too much exposure to one sector, entity or asset class — controlled by exposure limits.
Correlation: A measure, between −1 and +1, of how the prices of two assets move in relation to each other.
Diversification: Reducing portfolio risk by holding uncorrelated or negatively correlated assets, so one asset's bad period is offset by another.
Emergency cash: A liquid reserve usually equal to two to three months' spending, or more if income is volatile.
Factor-based investing: Selecting and weighting securities on characteristics such as value, momentum, size, quality or low volatility, rather than market capitalisation.
Factor cyclicality: The risk that a factor stops working for extended periods, since not all factors work at all times.
Goal sheet: A table listing each financial goal with its priority, time period and amount needed.
Investment approach: The documented investment philosophy a portfolio manager follows for a client, including types of securities and proportion of exposure.
Investment constraint: A limit on taking certain exposures because of liquidity needs, time horizon, tax, regulation or personal preference.
Investment Policy Statement (IPS): The road-map document, drafted with the investor, setting out objectives, goals, constraints, preferences and risk tolerance. The first step of portfolio management.
Liberalised Remittance Scheme (LRS): RBI scheme allowing resident individuals, including minors, to remit up to USD 2,50,000 per financial year for permitted transactions.
Net worth: The value of everything you own at estimated market value, minus everything you owe.
Rebalancing: Adjusting a portfolio back to its desired allocation after market movements make it drift.
Risk capacity: The investor's financial ability to take risks.
Risk profiling: Assessing an investor's risk tolerance, objectives and financial situation, usually through a questionnaire with weighted scoring.
Risk tolerance: The investor's willingness to take risks.
Smart beta: Index-based investing that departs from market-cap weighting to emphasise factor exposure.
Strategic Asset Allocation (SAA): A long-term plan with fixed target proportions across asset classes, periodically rebalanced. Suited to passive investors.
Strategy (PMS): The broad theme each investment approach is tagged to — equity, debt, hybrid or multi-asset. One strategy per investment approach.
Tactical Asset Allocation (TAA): Active, temporary shifts in asset weights within a predefined range to exploit short-term market conditions.

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Original explanatory writing based on the official NISM workbook for Series XXI-A, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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