Everyone has heard the old adage that it’s unwise to put all of your eggs in one basket. That’s because if something happens to the basket – it gets lost, falls, or meets with some other accident – you lose all of your eggs at once.
Portfolio optimization is a little like that. Putting all of your money into a single company, asset type, sector, or geographical region is risky. If something goes wrong, you could possibly lose everything. By optimizing your portfolio, you balance potential returns with the level of risk to ensure that a disaster with one of your holdings doesn’t leave you empty-handed.
Of course, there is far more to portfolio optimization than expanding the number and type of holdings – referred to as diversification – without careful consideration. A deliberate strategy ensures that you meet your financial goals while maximizing returns and minimizing risk.
What Is Meant By Portfolio Optimization?
Choosing a collection of assets based on their individual characteristics is just the beginning when it comes to portfolio optimization. What is meant by portfolio optimization is selecting assets that show promise on their own, then looking at how those assets are connected to each other to create a portfolio that meets your financial needs.
Some assets tend to increase or decrease in value at the same time. This is referred to as a positive correlation. For example, two successful companies in the same industry tend to see share prices increase or decrease simultaneously.
Uber and Lyft tend to move together, though perhaps at different rates. So do Bank of America (BAC) and Wells Fargo (WFC), Kroger (KR) and Safeway, and Walgreens (WBA) and CVS (CVS).
On a larger scale, entire classes of assets tend to rise and fall together, as do securities from particular regions. In one memorable example, the Chinese stocks trading on US exchanges collectively lost 15 percent of their value over the course of two days in July 2021.
On the other hand, there are assets that move in opposite directions. When one goes up, the other goes down. This is referred to as a negative correlation. For example, as a class, stocks and bonds tend to be negatively correlated.
Another well-known example of negative correlation is the relationship between airline stocks and oil prices. Airlines spend an enormous amount on fuel, so when oil prices go up, airline profits – and their stock prices – go down.
A portfolio optimization strategy examines these relationships to determine which holdings are positively correlated and negatively correlated. The portfolio is constructed with balance in mind, selecting assets that will deliver strong returns while – collectively – minimizing the risk of extreme losses.
Why Is Portfolio Optimization Important?
When you are absolutely certain that you have found a perfect investment – one that reliably delivers the returns you want – you might wonder why is portfolio optimization important? The short answer is that no investment is risk-free. Even keeping cash in a safe carries some level of risk. Aside from theft, the biggest is loss of purchasing power over time due to inflation.
Consider the investors who put all of their metaphorical eggs in baskets like Enron, Theranos, and Madoff-managed hedge funds. On the surface, these appeared to be high-reward, low-risk opportunities, but in truth, their investors eventually lost everything.
These examples of fraud aren’t especially common, but the same risk of heavy losses applies to any individual holding. For example, those who invested in WeWork lost substantial sums as a result of what can be charitably described as shockingly poor management.
Another example impacting an entire class of assets occurred in January 2022. When the Federal Reserve confirmed it would raise interest rates in the near future, stocks as a whole declined. The Dow Jones Industrial Average went down 1.1 percent, the S&P 500 dropped 1.9 percent, and the Nasdaq lost 3.3 percent.
Investors who had all of their holdings in stocks saw an abrupt downturn in the value of their portfolios. However, investors who pursued a portfolio optimization strategy saw those losses mitigated or erased by gains in other assets.
While a properly optimized portfolio won’t see the dramatic returns that come with investing in a single rapidly rising asset, the level of risk is far more tolerable. Better still, the level of risk represented in each investor’s portfolio can be customized based on unique factors like risk tolerance and investment horizon.
What Kind of Optimization Techniques Are Used In Context of Portfolio?
At a high level, the most common optimization techniques that are used in context of portfolio are as follows:
- Mix of Asset Classes – Asset classes don’t typically move in lockstep. Stocks and bonds are negatively correlated, and other types of assets have their own patterns. For example, stocks and gold are often also negatively correlated. Commodities, cash, and contracts are asset classes with other characteristics that can contribute to a portfolio optimization strategy.
- Mix of Industries, Sectors, and Geographies – Once you have found the right mix of asset classes, the next step is to diversify within those asset classes. For example, choosing only tech stocks or limiting yourself to income-generating Bonds can work against your portfolio optimization goals.
- Mix of Risk Profiles – Finally, examine the risk profile for each asset you are considering for your portfolio. After all, just because they are in the same class doesn’t mean assets have equal risk. Tech startups such as Roblox, Coinbase, and Robinhood appear promising, but it’s too soon to tell how successful they will be over time. To date, only Coinbase is turning a profit. Any one of these might have a place in a portfolio optimization strategy, but high-risk options should be balanced with more dependable stocks. Within the tech sector, blue-chip stocks like Alphabet (GOOG), Amazon (AMZN), and Apple (AAPL) can offset the risk you take on with a new arrival.
Finally, optimization techniques that work for you now might not be a good fit later. The risk/reward balance that feels right when you are young and single may change when you start a family or put more focus on long-term financial goals. Reworking your portfolio optimization strategy regularly ensures that your current needs are being met.
How Do You Optimize A Portfolio?
When you get into the details of how do you optimize a portfolio, there are a variety of methods. However, the first two steps are the same no matter which method you ultimately choose.
First, take an honest look at your ability to tolerate risk. If you are after high returns, but you tend to sell every time a stock dips, you can’t succeed with a high-risk/high-return potential portfolio. More reliable, less volatile assets are a better choice for building long-term wealth.
Conversely, if you have nerves of steel and you can watch prices soar and fall with ease, you might consider higher-risk/higher-reward potential assets. You can include more assets like promising tech startups as you build your portfolio.
Second, examine your investment horizon.
Realistically, what are your financial goals, and when do you want to meet them? If you know you will need to liquidate your portfolio in five years to purchase a home, or you plan to retire in ten years and have a certain lifestyle in mind, you can’t afford excessive risk.
Alternatively, if you are starting to save for a retirement that is 40 years out, or you are investing an amount that you can afford to lose, you have the flexibility to select higher-risk/higher-reward potential assets.
With these two points in mind, the next step is to choose specific assets. This step involves research and analysis. For securities, you will examine the fundamental strength and potential of a company based on factors like financials, market, and management, then create a risk profile for each of your short-listed stocks.
In addition, you may wish to complete certain forms of technical analysis, which examines patterns in pricing behavior over time. The same sort of research goes into other asset classes, but it tends to be less intensive than the research necessary for stocks.
The good news is that you don’t necessarily have to conduct fundamental and technical analysis independently. In many cases, this analysis is already available through online tools, professional analyst reports, and independent investor education sites.
How Do I Choose A Portfolio Weight?
You have considered your risk tolerance and your investment horizon, and you have selected the assets you want to include in your portfolio. However, there is still a final step in the portfolio optimization process. You must determine what weight to give each asset class, as well as how you will weigh individual assets within classes.
Quite a bit of calculation goes into creating an ideal weighting strategy based on your current circumstances. Fortunately, you don’t have to do those calculations yourself. Most online brokerage firms and investor education sites offer software and tools to complete these calculations using formulas that have proven effective over time.
A very simple example of weighting might look like this:
- Stocks – 70 percent
- Bonds – 30 percent
Within those asset classes, additional weights are assigned based on the level of risk. For example, of the 70 percent invested in stocks:
- High-Growth Stocks – 60 percent
- Blue-Chip Stocks – 40 percent
Within those risk categories, more weights are assigned. For example, blue-chip stocks might be divided by sector:
- Technology (e.g., Microsoft, Intel) – 20 percent
- Financial (e.g., JP Morgan Chase, Goldman Sachs) – 20 percent
- Consumer Staples (e.g., Walmart, Johnson & Johnson) – 20 percent
- Media & Entertainment (e.g., Disney) – 20 percent
- Restaurants (e.g., McDonald’s, Starbucks) – 20 percent
The specific portfolio weights for each asset class, risk category, and sector depend on the unique needs of each investor, which goes back to risk tolerance and investment horizon.
What Is A Good Portfolio Mix? The Bottom Line
In terms of what is a good portfolio mix, the bottom line is that there is no one-size-fits-all answer. The portfolio mix that is right for you won’t be right for your parents, your co-workers, or your neighbors.
On top of that, a good portfolio mix today won’t necessarily meet your needs tomorrow. As you experience changes in your life, your portfolio optimization strategy should be adjusted to support your revised financial goals.
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