Principles of Portfolio Optimization

Is it time for you to take a look at your investment portfolio and make some changes? Whilst it is important to set up a robust portfolio, it’s just as important to maintain that portfolio and ensure that it’s performing as well as possible to meet your investment goals. This article will help you get to grips with the jargon and tools available to assist you in optimising your own portfolio.

portfolio optimization

Portfolio Optimization – What is It?

When originally constructing your investment portfolio, you will have ascertained your risk appetite and investment goals and chosen your investments accordingly. However, over time, you will discover that certain assets will perform better or worse than predicted.

It’s 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’s important to put time into actively managing your investments, which is known as portfolio optimisation.


Asset Allocation 

Your portfolio is made up of a group of asset investments. These could include shares, bonds, commodities such as oil and gold, fund investments and alternative investments such as fine wines or classic cars. The assets which you choose to make up your portfolio should be carefully selected 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.


Performance Analysis

The first step in actively managing your portfolio is to analyse how your investments are performing.  It’s important to monitor the risk and return of all of the asset classes making up your portfolio as this data will determine your future investment choices. Professional asset managers have the benefit of specialised software, such as APT, to assist them with their analysis.

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 analysis

Risk Decomposition

The key to a robust investment portfolio is to diversify your assets. 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 Be Aware Of

You must always remember that the value of your investments can go up or down. Even with assets which are generally considered to be low risk, you could be affected by changes in interest rates and credit risk. You must also ensure that you include any applicable fees in your calculations, as these will cut into any profit you make.

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.

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  1. I believe asset allocation is more important than actually picking stocks. I never have more than 5% of my portfolio in one position no matter how confident I am in the investment. Additionally I always maintain a 25% stop loss which would result in a lost of .0125% of my portfolio if an investment goes against me.

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