What is Portfolio Optimization?
Portfolio optimization is the process of choosing the optimal portfolio (asset distribution) from a set of all possible portfolios based on some criteria. Typically, the goal is to maximize elements like expected return while minimizing costs like financial risk.
Stock portfolio optimization is both a process and a goal. The process, which is also known as strategic planning, assists you in defining expectations and setting investment goals that are in line with them.
While there's no denying that investing in the stock market has some risk, managing your stock portfolio can help you make better investment decisions, stay on track, and ultimately maximize profits.
How portfolio optimization does help you to make a higher return and reduce loss?
As portfolio optimization is simply selecting the best stock in your portfolio to reach your investment goal. Let’s calculate the portfolio return considering you have invested in the two stocks named XYZ and PQR. (50% of the amount in each XYZ and PQR).
As we are investing 50% each in XYZ and PQR portfolio is equally weighted. Let’s assume XYZ Stock fetches a return of 24% and PQR Stock fetches a return of 16%.
As a result, the expected portfolio return will be -
Portfolio return formula
= Weight of investment in XYZ * Expected return of XYZ + Weight of investment in PQR * Expected return of PQR
= 50 % * 24 % + 50 % * 16 %
=12% + 8%
Hence, 20% is the expected return the portfolio will yield annually. What if you change the weight?
Instead of investing 50% each in the Stock XYZ and Stock PQR, let’s say you are investing 70 % in the Stock XYZ and the remaining 30 % in Stock PQR. So, portfolio return would be –
= 70 % * 24 % + 30 % * 16 %
=16.8% + 4.8 %
Simply put, we can execute this for a variety of weight combinations. Here’s the detailed table of various combinations -
As you can see investment weights varies the expected return earn also varies. If you would have optimized my portfolio by investing 40% in Stock XYZ and 60% in Stock PQR then the expected return would be 19.20%.
Whereas, if your portfolio optimization is investing 60% in Stock XYZ and 40% in Stock PQR then the expected return would be 20.8%.
By just inter-changing the weights you can earn an extra return of 1.6 %. Proper and suitable portfolio optimization helps you to make an efficient portfolio.
You can easily make this portfolio in excel.
What is Variance Optimization?
A mean variance optimization analysis is a risk-spreading strategy that investors employ to distribute risk throughout their portfolios. The investor calculates the risk of an asset, which is expressed as "variance," and then compares it to the asset's anticipated return. It seeks to maximize an investment's yield while minimizing its risk.
As we saw each weight change in the portfolio optimization helps us to earn a different return. Variance optimization helps to reduce the risk along with increasing the returns.
There are different types of variance optimization that are suitable for different investors’ profiles as risk-averse investors or aggressive investors.
1. Minimum Variance Portfolio
When the variance optimization of the portfolio is minimum, the portfolio’s volatility is kept minimal. This kind of portfolio is also referred to as a Minimum Variance Portfolio. You can take the least amount of risk with a minimum variance portfolio. If you are a risk-averse investor, you should attempt to build a portfolio with the lowest possible variance optimization.
2. Maximum return portfolio
This is the polar opposite of a minimum variance portfolio optimization. A mixture of weights, similar to a minimum variance portfolio, should be used to create a portfolio with the highest potential return. This also indicates that the risk associated with a maximum return portfolio will be larger. The aim of maximum variance optimization is to increase the potential return earning.
What is an efficient portfolio?
Investable assets are integrated into an efficient portfolio to yield the best feasible projected level of return for their level of risk—or the lowest risk for a target return. The efficient frontier is the line that connects all of these portfolios.
Portfolio optimization helps to make an efficient portfolio with proper portfolio management strategies.
Portfolio management entails putting together and managing a portfolio of investments to meet an investor's long-term financial goals and risk tolerance.
In order to outperform the market, active portfolio management entails systematically buying and selling stocks and other assets.
Passive portfolio management aims to replicate market returns by simulating the composition of a specific index or indexes.