By Vinny and Jeff, JAVLIN Invest
Whether you’re a seasoned investor or just starting out, you’re likely seeking low risk investments, paired with strong rewards. While nearly everyone is pursuing this perfect balance in their portfolio, striking it is no easy feat. Luckily, portfolio optimization provides a method that can help achieve it over the long haul.
But what exactly is portfolio optimization—and how can you go about using it in your long-term investment strategies? In this article, we walk you through portfolio optimization: the definition, benefits, and easy ways to put it into practice so you can start making informed decisions about your long-term investments.
What is portfolio optimization?
Portfolio optimization is the process of selecting the best possible investments according to a set of desired outcomes, usually maximum return at either a capped risk, or the lowest possible level of risk for a specified return. It’s based on a school of thought called Modern Portfolio Theory (MPT), created by American economist Harry Markowitz in the 1950s. According to MPT, diversifying your investments across various asset classes is the best way to minimize risk while maximizing return.
By selecting assets that are dissimilar—or, in technical terms, have low correlation—your portfolio will be better positioned to weather widespread market changes. If and when one class of assets underperforms, your investments in other asset classes will help keep your portfolio balanced. This reduction of risk is what makes portfolio optimization such an appealing investment strategy for long-term investors.
Why should I optimize my portfolio?
While we explained one of the core benefits of portfolio optimization above—lowest possible risk at a desired return, or highest possible return at a chosen level of risk—there are several other reasons why it makes sense to optimize your portfolio.
When properly executed, portfolio optimization can:
- Reduce idiosyncratic risk: Portfolio optimization can greatly reduce idiosyncratic risk, or risk that impacts a single asset or class of assets. Idiosyncratic risks can be internal issues companies face—like management and internal policies changes—or risks specific to the industry that ultimately lead to falling asset values. While portfolio optimization can’t guard against systematic changes—like rising interest rates, recessions, and new federal policies—it can limit idiosyncratic risks through diversification.
- Factor in your personal situation: Portfolio optimization allows investors to center investments around the amount of risk they’re willing to take on given their current stage of life or risk tolerance levels. Investors nearing retirement are typically averse to risk, while young investors with plenty of time to recoup losses can generally handle more. Once decided, portfolio optimization strategies can provide the greatest amount of return at that risk level.
- Limit human error: By strategically investing across a number of asset classes, investors using portfolio optimization strategies can bypass the mistakes many early investors make: investing in stocks that appear to be strong without considering the portfolio as a whole.
- Offer greater precision: Through portfolio optimization, investors see exactly how much they should allocate toward each asset for the greatest chance of realizing their desired outcomes.
Ultimately, portfolio optimization allows you to maximize your potential reward to risk ratio. As such, it’s a strategy favored by those seeking a balance of potential payout and possible losses according to their life circumstances.
How do I optimize my portfolio?
To optimize your portfolio, you first need to decide which classes of assets to invest in. Next, figure out how much to invest in each according to desired risk and return—but calculating these proportions can be time consuming and confusing.
Author Vinny and Jeff, JAVLIN Invest
Before launching JAVLIN Invest, Vinny was a portfolio manager at Providence Capital Management, while Jeff worked as a risk management executive at Mutual of America — experience and background that allows them to know what data is needed for people like their friends to effectively manage – and maximize – their portfolios.