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A Guide to Portfolio Optimization Strategies

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portfolio optimization
There are some financial chores you might have down to a science, like budgeting, filing  taxes or auto-payments. And if you’re an investor, you should add portfolio optimization to this list. With regular portfolio review, you can make adjustments and increase the likelihood you’ll end up with comfortable returns instead of frustrating results. A few quick exercises can help make portfolio optimization more straightforward. If you’re just getting started, a financial advisor may help you establish routines for a lifetime of investing.

What Is Portfolio Optimization?

You might already know portfolio optimization by another name, such as ‘optimal asset allocation’ or ‘modern portfolio theory’.  But no matter the name, the idea and objective are the same. You want to build your portfolio to yield the maximum possible return while maintaining the amount of risk you’re willing to carry.

This means creating a balanced portfolio, which means want to spread your investment capital across a variety of assets. Then, you’ll balance those assets in order to attain your desired risk-reward outcome.

Portfolio optimization should result in what investors call an ‘efficient portfolio’. This means it’s generating the highest possible return at your established risk tolerance. (Alternatively, this term may refer to a portfolio that has the minimum amount of risk for the return that it seeks, although it’s a less common usage.)

Asset Classes and Optimization

Any portfolio optimization strategy will apply the concept of diversification, which means investing in a wide variety of asset types and classes.

Diversification across asset classes is a risk-mitigation strategy. Financial asset classes include different types of securities, debt and equities that you can hold. Furthermore, every asset has a  distinct return and risk profile. Critically, different asset classes have different ‘systemic risk’, which describes how they respond to the market at large. For example, when the stock market does well, commodities and bonds tend to do poorly. Conversely, commodities and bonds rise when stocks fall.

Ideally, spreading your investments across a variety of asset classes allows you to take advantage of different systematic risks. Some of the popular asset classes include:

  • Bonds Debt instruments issued by governments and large organizations.
  • Income-Generating Bonds This is a sub-set of bonds that pay interest on a regular basis.
  • Stocks Shares of ownership issued by private companies, which typically break out into large, mid, and small-cap categories according to the size of the issuing firm.
  • Commodities Ownership of goods or products, typically raw resources, which trade based on their future prices.
  • Contracts Instruments issued by private parties such as certificates of deposit and annuities.
  • Cash and Equivalents Money in a bank account or other secure assets that you can liquidate immediately.

Most retail investors avoid direct contact with commodities and bond markets, since these tend to be high-risk classes. The alternative is buying into mutual funds or exchange traded funds that buy into these assets. For example, instead of taking on the considerable risk involved with trading commodities contracts in precious metals, you could purchase a mutual fund pegged to the price of gold. It’s less expensive, less risky and far more accessible.

What Is Risk?

At its most basic definition, risk is the chance that you’ll lose money on an investment or won’t see the returns that you expected. However, investors also measure risk through volatility, which refers to the likelihood an asset’s price will change significantly.

This is one reason risk and reward often correlate. An asset with strong volatility can deliver or lose a great deal of value. That range of potential outcomes makes the asset hard to predict and, therefore, risky.

Strategies for Portfolio Optimization

portfolio optimization
This is where the rubber meets the road and your personal approach to investing and portfolio optimization goes into action. While the timeless advice of ‘figure out what works best for you’ applies, there are a few key techniques to understand.

Note that all examples below are greatly simplified. Investing professionals use complex formulas to determine portfolio optimization, and there are many software packages and robo-advisors that help independent investors reduce their mathematical heavy lifting.

Asset Weighting

When optimizing your portfolio, you assign  an ‘optimization weight’ for each asset class and all assets within that class. The weight is the percentage of the portfolio that concentrates within any particular class. For example, say we weight stocks at 10% and bonds at 20%. This means bonds are twice as important to our portfolio as stocks. So, we could then assign sub-weights to slow-growth stocks and fast-growth stocks at 20% and 10%, respectively. Any stocks selected for this portfolio would need to establish and maintain these ratios.

You assign asset weights based upon your risk and return tolerance. If you hope to minimize risk you would assign greater weight to low-risk, low-growth assets. This is what we have done in the above example by assigning twice as much weight to safe investments as profitable ones.

Selecting Weight for Optimization

Determining asset weights is where value judgments impact the optimization process. You need to consider your investing goals, how many years you have until retirement and your risk tolerance. Once you’ve made this personal assessment, you’ll assign weights to different asset classes that keep risk and return preferences in balance. You’re seeking what some investors call the ‘efficient frontier’: the maximum amount your investments can earn given your established risk level.

For example, if you decide you’re comfortable with a 20% risk of loss, you want to build a portfolio that can make the most money possible without exceeding that threshold. So you might pick the following assets for your portfolio based on each one’s promised returns:

  • Bond ABC; Risk 10%
  • Stock XYZ; Risk 50%
  • Stock TUV; Risk 30%
Calculating Asset Weight

Now we need to calculate our weights. In a non-optimized portfolio, we might place too much money in Bond ABC, thus reducing our possible returns, or over-invest in Stock XYZ, which would create too much risk. So, we need to calculate exactly how much of each stock we want:

  • Weight(ABC) + Weight(XYZ) + Weight(TUV) = 1 Together these three assets will make up the whole portfolio. For the purposes of math, we are representing percentages as decimals, so 100% is  ‘1’.
  • .1*Weight(ABC) + 0.5*Weight(XYZ) + 0.3*Weight(TUV) = 0.2 The average risk you want in your portfolio is no more than 20%.

Astute readers will note we can’t solve this formula. We have too many variables. We need to fix that by making a judgment call. Where do we want to put our emphasis? We have a low risk, a mid-risk and a high risk asset, each with proportional rates of return.

A Theoretical Optimization Equation

Let’s say we value safety over growth. So we put only 10% of our money in the riskier StockXYZ. We would optimize our portfolio by keeping our outcome (20% risk) fixed and investing as follows:

  • Weight(ABC) + 0.10 + Weight(TUV) = 1
  • 1*Weight(ABC) + 0.5*0.1 + 0.3*Weight(TUV) = 0.2

Now we have a solvable equation:

  • Weight(ABC) + Weight(TUV) = 0.9 Our portfolio is 10% StockXYZ and 90% everything else.
  • Weight(ABC) = 0.9 Weight(TUV) So the amount of BondABC in our portfolio is 90% minus the weight of StockTUV.

Which brings us back to the first equation:

  • 1*(0.9 Weight(TUV)) + 0.5*0.1 + 0.3*Weight(TUV) = 0.2

We now know that the weight of BondABC is just the remainder after subtracting the weight of our other two assets. We can use that as our variable and solve.

  • 1*(0.9 Weight(TUV)) + 0.05 + 0.3*Weight(TUV) = 0.2
  • 1*(0.9 Weight(TUV)) + 0.3*Weight(TUV) = 0.15
  • .09 0.1*Weight(TUV) + 0.3*Weight(TUV) = 0.15
  • 0.1*Weight(TUV) + 0.3*Weight(TUV) = 0.06
  • 0.2*Weight(TUV) = 0.06
  • Weight(TUV) = 0.3
  • Weight(ABC) = 0.9 Weight(TUV) = 0.6

Our optimized portfolio will have 60% of its assets in BondABC, 10% in StockXYZ and 30%  in StockTUV. This lets us invest 10% of our money in the high-risk, high-performance potential StockXYZ while maintaining a comfortable 20% risk profile.

Remember, this is a highly simplified example. Professional investors use far more complex formulas than a simple average to weight their portfolios. But no matter how advanced the math becomes, it boils down to the same basic principle. Smart investors build a formula to allocates set percentages of their capital into risky, high-reward assets and safer assets.

Time Strategy and Optimization

Investors optimize their portfolios to maintain a risk-reward balance that meets their current needs. To do this, they must regularly change the composition of a time-sensitive portfolio.  Investors may be much more open to risky assets when they have many years to earn money back if an asset loses value. However, if they’re close to retirement, or the year their child will start drawing on a college fund,  they probably can’t tolerate so much risk. That’s because there’s less time and portfolio flexibility to manage losses.

Portfolio optimization is an essential tool in this process. Whether you take a DIY approach or use professional services, many factors will affect the variables and equations over time. But with regular check-ins and maintenance, you can keep your investing on target.

The Bottom Line
portfolio optimization

Portfolio optimization is an important part of creating an investing strategy and managing it over time. It requires a sensible assessment of your desired returns, stage of life, risk tolerance and investment preferences. Once you’ve established these values, you can work up numbers and percentages that reflect and, hopefully, support them.

Many investors can create and execute a portfolio optimization strategy on their own. That said, many more rely on professional help or algorithms to do this important work satisfactorily.

Tips for Investors
  • There are good rules of thumb to follow regarding asset allocation and how you may adjust your portfolio as you age, But you can also use tools, such as asset allocation calculators and  retirement calculators, to help you visualize your current situation and anticipate how your investment priorities may change.
  • Professional advisors can help walk you through some of the complexities of portfolio optimization without burying you in details. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.

Photo credit: iStock.com/utah778, iStock.com/alubalish, iStock.com/courtneyk

The post A Guide to Portfolio Optimization Strategies appeared first on SmartAsset Blog.

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