Whether you decided to stick to mutual funds and ETFs or adventure into security selection, or a mix of the two; this step is essential if you want your portfolio to yield great returns while controlling risk.
In this section, we will explain the process we follow to optimize any portfolio.
We have seen how portfolios are collections of individual assets that behave independently but when owned together, they form a unique asset that behaves as its own.
We started discussing portfolio management and what it means. It is essentially the act of trying to find the right mix of assets to form a portfolio that is right for the investor, that is optimal and matches the investor’s objectives and constraints we talked about earlier.
Most of what you have been learning in this course is related to portfolio management to some extent.
Once we have determined our objective and constraints, created a set of expectations, and selected the assets we want to invest in, we will be ready to find the right allocation percentages to minimize risk while still achieving our objectives.
Modern Portfolio Theory (Simplified)
In order to find the perfect mix for us, we have to understand the basics of something called Modern Portfolio Theory.
The main idea behind this concept is diversification, which we have already talked about. This theory essentially says that if you incorporate assets in your portfolio that have very little or negative correlation amongst themselves (they move in different directions most of the time), regardless of their high or low volatility, you may actually reduce your portfolio’s volatility while maintaining solid returns.
A good example of an application of this theory is the combination of stocks and bonds because they generally have low or even negative correlations. Below we can see a two-year comparison of the performance of both (stocks being represented by the SPY and bonds by BND, two of the most commonly used asset benchmarks):
We can see how they move differently and sometimes even in opposite directions. So, if we follow the Modern Portfolio Theory, we would ideally invest in some combination of both assets in order to minimize volatility without affecting the returns much.
Find out more in future sections.
In previous sections, we have seen that, in investing, there is a necessary relationship between risk and return. This means that higher returns will come with higher risks and vice versa.
One of the best (and standard) ways of measuring the risk-adjusted returns is the Sharpe Ratio, which we use as the main criterion to optimize our portfolios.
Refresher: Sharpe Ratio is the excess expected return (expected return minus risk-free rate) per unit of risk (standard deviation).
(Expected return – Risk-free rate) / Standard Deviation
The goal of portfolio optimization is to find the asset mix that can achieve the best Sharpe Ratio over your investment period.
The Modern Portfolio Theory tells us that it is possible to maximize our portfolio’s expected return for any given level of risk. The portfolios that can do that are known as efficient portfolios. However, the risk-return relationship still stands; so, investors that require higher returns will have to bear higher risks, this is known as the trade-off between risk and return.
This risk-return relationship of efficient portfolios can be graphically represented in a curve called the efficient frontier line.
The above is a great example of an efficient frontier line chart.
- The horizontal (x) axis lays out the volatility measure (the standard deviation) of the portfolios.
- The vertical (y) axis shows the expected return measure of the portfolios.
- Each asset is displayed in a different-colored dot.
- The cluster of purple-blue dots represents 100,000 possible asset allocations.
- The red line is known as the Efficient Frontier Line. It outlines the perfect portfolio combinations in terms of risk and returns. A combination that is above the line is not possible.
- The big, dark purple dot represents the optimal portfolio that maximizes the expected returns and minimizes risks.
In Bullglobe, we position ourselves on the line (see the big, purple dot) and give you the best combination in the universe of possibilities.
Find out all about the efficient frontier line and how we get to it in future sections.
The optimal portfolio
The process we follow to achieve the optimal portfolio is simple in theory but it is fairly difficult to achieve in reality.
We have developed a program that takes in your objectives and constraints and analyzes past data and some forecasted outcomes in order to provide us with your optimal portfolio, which is updated on a daily basis.
This process is called rolling optimization. It allows us to maximize the portfolio’s Sharpe Ratio and provides a clean, flowing rebalancing tool to maintain a constantly optimized portfolio.
Next, we will go over what portfolio rebalancing is and we will discover some amazing strategies and tools to do it right.