By Jess Peterson
Finance and investment guru Benjamin Graham said, “Successful investing is about managing risk, not avoiding it.” These are wise words no matter if you’re new to investing or a seasoned pro.When it comes to accomplishing your investing goals, portfolio optimization is crucial. 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. But 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
If you already have a financial professional in your corner, ask them about the portfolio optimization strategies they use with your financial plan. And if you’ve been winging it on your own up until now, or you’re looking for some additional insight or a second opinion, we at Peterson Wealth Management would be happy to provide a complimentary review of your portfolio.
We know that sometimes money can be hard to talk about, and we aim to put you at ease while answering your questions in a clear, objective manner. Schedule your no-fee consultation now!
Jess Peterson is an investment advisor representative at Peterson Wealth Management, an independent, full-service financial advisory firm committed to providing personalized, unbiased advice. With over 12 years of experience, Jess serves his clients by developing strategies for the myriad of financial challenges and opportunities they face as they move through life, educating and empowering them so they can make informed decisions that get them closer to their goals. Jess is known for building strong, long-term relationships with his clients built on trust, and he works tirelessly to reduce their financial stress so they can focus on the things they love. Jess graduated from the University of Nevada, Reno with a bachelor’s degree in economics and political science. When he’s not at work, you can find Jess staying active by running in various events around Northern Nevada and racing motorsports around the country. He enjoys visiting Tahoe, playing hockey, and snowboarding as well. To learn more about Jess, connect with him on LinkedIn. You can also watch his free webinar on 7 Unexpected Risk to Your Retirement (& How to Plan for Them).