By Paul S. McNulty, CFP®
Whether you’re new to investing or a seasoned pro, portfolio optimization is crucial to accomplish your investing goals. If you manage your own portfolio, you may be employing some portfolio optimization strategies without even realizing it. Likewise, if you consult a financial professional to manage your investments, they use portfolio optimization models daily. So what exactly is portfolio optimization, and how is it used in investing?
Portfolio optimization attempts to achieve the highest possible return, given exposure to a certain level of risk. Every investor wants to maximize returns. However, investors need to factor in their risk tolerance when building portfolios as well. Everyone has a different risk tolerance based on personal preferences, investing goals, time horizon, and current life stage.
Diversifying your investments is key to managing this risk, and investors do that by holding different types of investments in their portfolios. Keeping various kinds of investments and weighting them appropriately for your goals is the baseline component of any portfolio optimization strategy.
Along with that, the types of assets you can fill a portfolio with are nearly endless. The question becomes, which kinds of investments do you utilize, given your risk tolerance? How do you select a suitable combination of assets for your portfolio among all possible combinations? Finally, how do you assign weights to those assets to give you the best chance of generating the highest potential return? Portfolio optimization helps investors and financial professionals answer these types of questions.
Portfolio Optimization Strategies
There are several different portfolio optimization strategies investors can employ, but four common ones are: (1)
● Equal weight
● Risk parity
● Minimum variance
● Mean variance
Investments are weighted equally across the entire portfolio. Equal weighting is typically employed to gain broad exposure to the market without bias.
Investments are allocated based on a target risk level. More risky asset classes are assigned lower weights, and less risky asset classes are assigned higher weights.
Minimum variance is designed to achieve a return while minimizing volatility. Investors accomplish this by investing in assets that negatively correlate in terms of performance. A typical example is stocks and bonds. When stock prices are falling, bonds are typically more stable, and vice versa. When done correctly, allocating investments in this manner typically reduces the level of volatility in the portfolio.
A central tenet of Harry Markowitz’s modern portfolio theory, mean variance portfolio optimization strives to generate the highest possible return for the level of risk you are personally willing to accept. This is achieved by diversifying assets in the portfolio according to the level of variance (risk) and desired return levels. Ideally, investors utilizing a mean variance strategy hope to strike a balance between risk and return.
Optimizing Your Portfolio
Next time you meet with your financial professional, ask them what portfolio optimization strategies they are using with your financial plan—looking for some additional insight or a second opinion? We’d be happy to provide a free review of your portfolio.
At Boston Metro Advisor, we’ll answer your questions in a clear, objective manner without the sales pitch. Contact us for a complimentary consultation by calling (781) 995-0253 or email me directly at [email protected] today!
Paul McNulty is the founder of Boston Metro Advisor with over 20 years of experience helping people navigate the ups and downs of the economy toward the financial future they envision. His education consists of a Bachelor of Science in business administration from the University of Rhode Island and the CERTIFIED FINANCIAL PLANNER™ (CFP®) professional designation.
Paul’s experience and education have made him a multi-faceted professional capable of assisting people with virtually all their financial needs. His services include every facet of retirement planning, from 401(k) rollover services and income planning to wealth management and estate planning. Paul has been active in his community over the years as a youth sports coach. When he’s not spending time with his wife, Cindy, and their two children, who are both recent college graduates, Paul enjoys reading, playing golf, and fishing. Learn more about Paul by connecting with him on LinkedIn.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
All Investing involves risk, including the possible loss of principal. No strategy assures success or protects against loss.