One only needs to look at the Dow Jones Industrial Average to see how beneficially or detrimentally variable the stock market can be. The market went from 6.43% in 2007 to -33.84% in 2008. But it also went from -33.84% in 2008 to 18.82% in 2009.
Investment portfolio holders didn’t need to experience significant losses. They could’ve only experienced significant gains during the upswing. You should want the same to happen to your portfolio.
This article will teach you some tips that can help you do just that. Read on to learn some portfolio optimization strategies.
What Is Portfolio Optimization?
Portfolio optimization is a portfolio management strategy that helps investors choose the best types of investments. What these are depends on the desired outcomes an investor has. Some may prefer aiming for the lowest possible risk while others want the maximum return.
It Can Involve Math
Investors often (but not always) have to use complex mathematical processes to select the best investments. But they don’t have to perform these complex mathematical equations themselves. They can get help from software, robo-advisors, portfolio managers, etc.
Do you want to choose someone or something else to perform the math for you? If so, your hardest endeavor will be choosing the right tool or person.
But if you don’t have enough money for these options, you can try tackling the math yourself. Just don’t expect to get the same results that you’ll get from a professional.
What Are Different Types of Investments?
Before you start comparing investments, you need to know which investments are available to you. You can then look at the gains and drops in their values and plug them into portfolio optimization formulas.
But knowing this can also somewhat help you with portfolio optimization in the beginning. You can use the known risks and returns of these assets to start managing your portfolio. Once you feel secure enough, you can start using the typical mathematical procedures.
Here are some examples of common investments:
Stocks (also known as equities or capital stocks) are portions of ownership in a company or corporation. If a person has stocks from a corporate entity, they own a part of it. How much they own depends on how many stocks they have.
Having stocks in a company gives a stockholder certain entitlements. They can gain earnings from the company, gain proceeds after asset litigation, and have some voting power in how the company is run. But the actual entitlements that investments gain can vary from stock to stock.
Investors can buy or sell stock privately or on stock exchanges. Investors often choose this investment option if they want high returns and can handle high risks. For the best risk management results, investors may want to mix stocks with other types of investments.
A bond is a type of loan and a fixed-income asset. The difference between it and regular loans has to do with who is loaning the money. For bonds, organizations, companies, or governments go to investors rather than banks or lenders.
In exchange for capital, entities will pay interest on the bond. When they pay the interest depends on the time intervals stated in the contract. On the maturity date (also stated in the contract), the entity will pay back the bond in full and end the loan.
Experts consider bonds to be lower risk than stocks, but it depends on who is borrowing the money. Some entities are more capable of paying back bonds than others
Cash or Cash Equivalent
When an analog or digital portfolio uses the term “cash”, it refers to the amount of cash that an investor has on hand. Portfolio management tools will often group cash and cash equivalents because they’re similar.
The phrase “cash equivalents” refers to short-term investing securities. They are considered cash equivalents because they’re highly liquid. Investors can easily convert them to cash when they need to.
Examples of cash equivalents include treasury bills, commercial papers, and certificates of deposit. Investors may want cash equivalent investments because they’re low-risk. But with this low risk comes low reward.
Commodity goods investment involves buying, selling, and trading raw materials. Examples of these include oil, wine, flour, and metals.
There are a few ways one can invest in commodities. Some investors will buy amounts of certain commodities all at once. The value of these can then rise or fall depending on outside circumstances.
Other investors will invest in commodities via futures contracts. These are agreements where investors buy or sell their commodities.
Commodities are great for portfolio diversity, but not for risk management. The factors that cause commodities to go up and down in price are often unpredictable.
Despite the name of this asset, investment experts do not classify cryptocurrencies as currencies. The exact classification varies. Some consider them to be securities or commodities while others consider them to be a distinct investment classification.
In a physical sense, a cryptocurrency is an alternative form of payment that exists as a digital file. A digital, distributed ledger (usually a blockchain) stores coin ownership records, creates additional coins, and verifies coin ownership transfers.
The way that an investor can profit from cryptocurrencies is similar to how they can profit from stocks and commodities. Ideally, they will buy a crypto coin or token for a certain price. Then someone else will buy it from them at a higher price.
Crypto assets are very volatile and rely on the optimism of the market. But this volatile nature can benefit investors. You just have to learn how cryptocurrency works.
Portfolio Optimization Methods
Investors or their tools will look at various types of investments in these subcategories. Then they will decide which investments to invest in based on the outcomes of the methods that they apply.
Diversifying your portfolio can make it more successful. Many amateur investors may interpret this as just buying a lot of different investments. But there is a more mathematical and exact way to approach this investment strategy.
This resides in Modern Portfolio Theory (MPT). Created by Harry Markowitz in the 1950s, this measures correlation to determine how two assets move gains or falls-wise. An investor determines the correlation coefficient by dividing the two assets’ covariance by their standard deviations.
Assets can have positive or negative correlation coefficients. They can rise and fall in the same ways (positive) or raise and fall in different ways (negative). Ideally, an investor should have several pairs of assets with negative correlations.
More volatile assets like stocks likely have different rise and fall patterns than low-risk investments like bonds. This seems obvious, but MPT can assure an investor that it’s a good idea to invest in both these assets.
Return on Investments
The return on investment (ROI) shows you how much profit or loss an asset gave you over a certain period. The formula to calculate this is very simple.
Take the initial price you paid for an asset. Subtract it from its current value. You should then divide the result by the initial value and multiply it by 100.
For example, say you bought a bottle of wine (a commodity) for $300. It is now worth $400. Subtract $400 by $300 and divide that by $300. After multiplying this by 100, you get an ROI of around 33%.
Unfortunately, you can’t use the return on investment equation before you invest in assets. However, you can use this formula to determine the strength of existing assets. Then sell off the assets that aren’t performing as you expect and/or want.
Conditional-Value-at-Risk (CVaR) is a measurement of the level of “tail risk” in a portfolio. The term “tail risk” refers to the likelihood of an asset dramatically falling below or rising above its average past performance.
Investors derive CVaR by first finding a weighted average of the tail of possible returns’ distribution. They then take this number beyond its value at risk (VaR) cutoff point. The value-at-risk model is a statistical technique that can measure the level of financial risk within a firm.
The initial VaR model is pretty simple. But having to apply it over a whole investment portfolio can get complicated. This is part of the reason why investors will use computer systems to help them.
Once they have the VaR, investors only need to plug it into the CVaR model. They will then know what they can expect to lose if an investment crosses over the worst-case scenario threshold.
Let Me Help Your Portfolio Grow
As you can see, the portfolio optimization formulas aren’t too complex. Still, they may be too much for some. If you’re not that good at math, you may want to get a professional to handle your assets.
My name is Joshua M. Peck and I can be that professional for you. I have more than twenty years of experience in risk management, systems engineering, and financial engineering. Let me use this experience to help your portfolio grow.
Schedule a consultation today using the yellow button at the bottom of this page.