In its most technical sense, portfolio optimization is a mathematical system for determining the ideal basket of assets to maximize returns at a given risk level. In simpler terms, an optimal portfolio is one that supplies the best return on investment for the least amount of risk.
Building an optimal portfolio is tricky and can be time-consuming. Ideally, you want to have a diversified portfolio of assets, that brings you the highest rate of return relative to the level of risk you’re willing to tolerate. This portfolio optimization problem will look different for different types of investors depending on several factors.
But how do you achieve portfolio optimization and what does it actually mean? Without getting too technical, today we’ll explore the portfolio optimization process, how to build the optimal portfolio, and the importance of portfolio management.
What is portfolio optimization?
As mentioned, the portfolio optimization problem is a complex mathematical process for a very common issue — choosing the ideal asset mix to create an optimal portfolio that balances risk versus reward.
Luckily, you don’t have to be a math whiz to take advantage of portfolio optimization. Between investment professionals, portfolio managers, software packages, and robo-advisors, there are plenty of individuals who can do that work for you. The hardest you’ll have to work is choosing the right advisor for you.
How does portfolio optimization work?
Coming up with the optimal portfolio for an individual takes into account factors such as:
- Investing timeline
- Tolerance for risk
- Expected return
- Investment goals
- The age of the investor
Modern portfolio theory poses that, in general, investments are either low risk with low rewards or high risk with high rewards. Therefore, investors who want to maximize their expected return with a minimal amount of risk should carry a mix of assets to make up an optimal portfolio. It’s also important to note that some investors will prefer a higher level of risk in order to achieve a greater return on investment.
But the exact mix, or portfolio weights, will differ between investors depending on their time horizon, risk tolerance, and investment objectives. For example, a common investment goal is to save for retirement. Though multiple investors may have this goal, each optimal portfolio will likely evolve depending on the age and risk tolerance of the investor.
Key concepts of the portfolio optimization process
Portfolio risk, timeline, and goals
Simply put, in financial terms, risk is the possibility that you’ll lose money on an investment. However, if you don’t expose yourself to any risk, like keeping all your money in a savings account, you won’t have the opportunity to reap the rewards that riskier investments can yield.
The main question an investor needs to consider is: How much risk am I willing to take on? And, taking it a step further, how much risk can I handle based on what I expect in returns? It’s also important to be aware that your risk tolerance will typically change over time.
Alternative investments are a good way to diversify your assets, which is good for riskier investors. But for ones that are risk-averse, they should do their research and seek out investment opportunities that offer reliable returns.” — Sundip Patel, co-founder and CEO of AVANA Companies
How does risk tolerance affect an investor’s timelines and goals?
Risk tolerance in general is different for everyone. However, when it comes to investing, you also need to consider your time horizon and ultimate investment goals.
For example, if you’re a young investor in your twenties you might be willing to take on more financial risks if your goal is to, say, retire before the age of 50. As a younger investor, you also have more time to recover from any large losses which can make higher risks seem more palatable.
On the other hand, if you’re an investor closer to retirement age, or one with a short-term goal, you may lean toward more conservative investments. For instance, if you’re saving for a down payment for a house you plan to purchase in three years, you wouldn’t be looking into a high-risk strategy. Instead, you would probably be more concerned with investments that provide a lower but steadier return.
Portfolio risk includes the combined risk of all investments in the portfolio, which modern portfolio theory tells us can be somewhat mitigated by asset allocation and diversity. Of course, market changes also play a large role in the risk to your portfolio.
“A good mix of assets includes general diversity, so if one area of the market isn’t doing too well, you have other assets that will perform well and balance things out,” says Sundip Patel, co-founder and CEO of AVANA Companies.
“Alternative investments are a good way to diversify your assets, which is good for riskier investors. But for ones that are risk-averse, they should do their research and seek out investment opportunities that offer reliable returns,” Patel advises.
Return on investment
A portfolio of investments isn’t doing you a lot of good if it’s not making you any money, at least over time. (It’s normal to expect ups and downs with many types of investment products in financial markets, and it’s nothing to be alarmed about.)
The return on investment (ROI) describes how much you have made or lost on any asset class or individual asset within a specific period of time, and the formula is very simple. Take the initial value you purchased the asset at and subtract it from its current value. Then divide that number by the initial value and multiply by 100.
For example, you bought a CD for $100 and now it’s worth $110. Subtract $110 from $100, which is $10, and then divide that by 100. This ultimately comes to 10%, which is your return on investment.
ROI is one the most important elements in figuring out how well your portfolio is doing overall in addition to each individual asset. Calculating your ROI can help you see the weaker spots in your investments and make changes accordingly to continue to optimize your portfolio.
One of the most important portfolio optimization techniques is that of having a diversified portfolio. This means having a mix of assets within a single portfolio. The primary purpose of a diversified portfolio is to spread out the inherent risks of investing so that no single asset has the power to make, or more importantly break, the entire portfolio.
Let’s say you had $10,000 to invest and you decided to put it all into Apple stock. Though the stock has done well in the past, it soon plummets and causes you to lose all of your money.
Alternatively, you decide to invest that $10,000 in a mutual fund or exchange-traded fund (ETF) that included shares of Apple in its basket of assets. While your profits aren’t as high compared to investing directly in Apple, your risks are diluted because you’re invested in multiple companies.
Portfolio optimization methods would suggest that an optimal investment portfolio would include a broad variety of assets. This might include domestic and international stocks, government and corporate bonds, and short-term investments such as CDs and money market accounts.
“Stocks and bonds form the core of most asset mixes. Stocks have tended to outperform bonds over the long-run [sic] but are more volatile and more susceptible to larger short-term losses. Bonds tend to produce more steady returns and if held to maturity produce definitive returns barring default,” explains Justin Zacks, Vice President of Strategy for the investing platform Moomoo Technologies, Inc. “The two asset classes are often negatively correlated. When this happens, losses in one class can sometimes be offset by gains in the other.”
Portfolio management and portfolio weights
Portfolio management can be either an active or passive strategy. Though you may start with one management style, you may very well want to alter your strategy and your portfolio weights in response to market changes, evolving investment goals, or your age. For example, a young, beginning investor may take a relatively passive approach to portfolio management. On the other hand, someone closer to retirement age may seek to take on a more active role, or vice versa depending on the asset mix.
It’s important to note that a part of portfolio management is also about risk management. Sticking with the above example, the younger investor may have an investment portfolio that’s heavily weighted with high-growth stocks — a relatively risky approach. As you age, you may want to rebalance your portfolio optimization strategy by seeking lower-risk investments, like bonds and CDs, and scaling back the asset weight of stocks.
“Remember that entering your investments in the market is only half the battle. Managing those investments once they are in place is the only way you optimize your investment portfolio,” says Jim Penna, Manager of Retirement Services at VectorVest Inc. “The ideal setting has the younger higher risk/reward-minded investor growing their portfolio over time and becoming less risk tolerant as they approach retirement.”
However, before you do any investing, you’ll need a brokerage account. To find the right account for your investing style, take a look at some of the accounts below.
Common types of asset classes
For those who are less experienced investors, it’s important to understand the different types of asset classes. Again, an optimized portfolio will have a mix of assets. An asset class describes a group of securities, like stocks or bonds for instance.
If a group of assets is part of the same asset class, then each asset will have similar characteristics, behave comparably in the marketplace, and be subject to the same rules and regulations. Here are some of the more common asset classes.
- Stocks. Also known as equities, stocks are shares of ownership in a company and are traded on the stock market. Stock returns can be very high risk but also have a high return. Investing in mutual funds or ETFs is a lower-risk way to invest in stocks.
- Bonds. Bonds are debt instruments issued by large organizations, corporations, and the government. Some pay at a maturity date, whereas others pay interest on a regular basis. Bonds are a type of fixed-income asset. Bonds have varying levels of risk but are generally considered lower risk than stocks.
- Cash or cash equivalent. Cash and cash equivalents are the lowest-risk investments that might be actual cash in high-yield savings accounts, money market funds, or very short-term investments (three months or less). This may include treasury bills or short-term certificates of deposit (CDs).
- Commodities. Commodities are usually raw materials or agricultural goods like silver, gold, energy resources, corn, and wheat. You can invest in commodities directly (buying gold bullion or purchasing futures contracts), or indirectly through mutual funds that invest in commodity-related businesses.
- Other alternative investments. Commodities are considered an “alternative investment,” but others include investments of varying risks such as hedge funds, venture capital, real estate, and art and collectibles.
Stocks and bonds form the core of most asset mixes. …The two asset classes are often negatively correlated. When this happens, losses in one class can sometimes be offset by gains in the other.” — Justin Zacks, Vice President of Strategy for Moomoo Technologies, Inc.
What are some common portfolio optimization methods?
While it’s not impossible to do the math yourself, there are financial professionals and software that can perform the data analysis for you. Different optimization models predict optimized portfolios based on different criteria, such as whether you’re prioritizing safety over growth, high growth over risk aversion, or somewhere in between.
These are some of the portfolio optimization methods used.
- Mean-variance optimization model (a.k.a. the Markowitz method)
- Mean semi-variance optimization model
- Conditional value at risk optimization (CVaR) model
- Mean absolute deviation model of optimization
What is meant by tail risk?
Tail risk is the chance of an asset either performing way below or way above its normal distribution — its average past performance — due to a rare event. To be considered a tail risk, the performance level must be three standard deviations from its expected return.
Not surprisingly, investors are less worried about extreme gains (the right tail “risk”) than they are about left tail risk, which is extreme loss. Tail risk can refer to either an individual asset’s risk or to the overall portfolio risk. An optimal portfolio, as defined by modern portfolio theory, should be better protected from this type of risk.
What is the efficient frontier?
In modern portfolio theory, the efficient frontier theory graphically rates portfolios on a scale of return versus risk. To find the efficient frontier, the asset returns are plotted on the y-axis and the risk measure on the x-axis. Return data depends on the combination of investments while the standard deviation represents the risk.
While the efficient frontier theory has merit in identifying optimal portfolios, it does not take into consideration factors like transaction costs, taxes, and other constraints.
What are the three elements of optimization?
Optimization in general means choosing the best option out of all available options. Every optimization problem has three components: an objective function, decision variables, and constraints.
- The objective function is the goal, like choosing the optimal portfolio.
- Decision variables are decisions within your control, such as the type and mix of assets you choose.
- Constraints are restrictions on your decisions, like how much money you have to invest.
- Portfolio optimization seeks to either maximize returns at a defined level of risk or minimize risk at an expected return.
- Portfolio optimization comes from the modern portfolio theory introduced by Professor Harry Markowitz in 1952.
- To achieve an optimized portfolio, an investor must first define their investment timeline, level of risk tolerance, and expected asset returns.
- True portfolio optimization is a mathematical puzzle. However, the average investor can seek advice from investing tools or financial management experts to attain an optimized portfolio.
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