Portfolio Optimization For Beginners

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You will always have to put time and effort into researching your investment options. It is important that you also make time to regularly review your investments and ensure they are still appropriate for you. This is the essence of portfolio optimisation. It will take a little time and effort, but it is as important as setting up a robust portfolio in the first place.

What is portfolio optimization?

Over time, you will discover that certain assets in your portfolio will perform better or worse than originally predicted. It is also possible that your risk appetite will change, depending on your personal circumstances, and your portfolio may no longer meet your requirements. It is for these reasons that it is important to put time into actively managing your investments, which is known as portfolio optimisation.

If you cannot afford to use the services of a professional investment advisor then you should set aside a time, at least once every six months, to review your investments and make any necessary changes to your portfolio. Click here to see what the professionals use to manage their assets.

Asset allocation

Your portfolio is made up of a group of asset investments which you have “allocated” to your portfolio. These could include shares, bonds, commodities such as oil and gold, fund investments and alternative investments such as artworks or classic cars.

The assets which you select to make up your portfolio should be carefully considered to ensure they meet your investment goals and risk appetite. A conservative investor will favour lower-risk assets such as bonds, whereas an aggressive investor will allocate higher-risk assets to their portfolio, such as stocks and shares.

Generally speaking, the nearer to retirement age you are, the more conservative your investments should be. However, everyone’s circumstances are different and, if you cannot determine how much risk you should take on, you will need to seek advice before proceeding further.

Performance analysis

The first step in actively managing your portfolio is to analyse how your investments are performing.  It is important to monitor the risk and return of all of your assets as this data will determine your future investment choices. If an asset is performing worse than predicted then you may want to reallocate your funds to a different investment. Likewise, if an asset is performing particularly well, you may want to divert more of your funds to this asset.

Risk decomposition

The key to a robust investment portfolio is to diversify your assets. You should consider diversifying not only the asset class, but also geographical region and risk type attaching to the asset.

Risk decomposition calculates the percentage contribution of risk of each asset within a given portfolio. Without knowing the risk attached to each asset it would be impossible to make informed investment choices. Calculating risk is an extremely complex task, requiring specialised software, as used by professionals in charge of hedge fund risk management.

A few things to bear in mind

You must always remember that the value of your investments can go up or down and sometimes even low risk investments lose money. Even with assets which are generally considered to be low risk, you could be affected by changes in interest rates and credit risk. This means that although the asset itself may appear to be turning a profit, any money you’ve made could be eaten up by an unfavourable exchange rate.

You must also ensure that you include any applicable fees in your calculations, as these will cut into any profit you make. Chopping and changing your asset investments too often may mean that any benefit is cancelled out by the fees payable.

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There is no such thing as an entirely risk-free investment, but optimising your portfolio on a regular basis will help you to take on only the amount of risk that suits you.