What is a Portfolio and portfolio optimization? why is it important?

It is essential to understand what is a portfolio and how can we be consistent for portfolio optimization.

Let us talk about Portfolio, it is the collection of financial assets such as stocks, bonds, shares, mutual funds, cash and so on which depend on factors like the income or earning of the respective investor, the time frame and the budget. There are two types of portfolio Market portfolio and Zero investment portfolio.

The investor wants to invest money so that he can reap huge returns or profits without facing any risk or we can say 0% risk. This is practically not possible but the risk can be minimised by implementing various ways and means to invest the capital.

Here comes the need of portfolio and risk management. The mantra for portfolio and risk management is: “Do not keep all your eggs in one basket”.

What is a Portfolio management?

The investor can distribute the amount to be invested into different financial assets. Diversified investments in the portfolio and the market return go hand in hand. The more diversified the investments in a portfolio; more is the chance that the investor will earn the same return as in the market.

Portfolio management is the art and strategy of choosing the right investment policy for and individual to maximise the returns or profits and minimise or decrease the risk which is liable to it.

In general terms, we can say that Portfolio management is the skill of how to distribute the eggs in other baskets so that if eggs one basket are damaged the eggs in other basket remains unscathed.

Why take up Portfolio Management?

Portfolio management provides the well-crafted investment plan to the investor according to their income, age, ability to take risks and their amount allocated for the budget. It recognises the financial needs of clients and suggests the best policy with minimum risk and maximum returns. In other words, it gives away the customised investment solution to the clients.

What are the types of Portfolio Management available?

The types of Portfolio Management available are:

  • Active Portfolio Management: As the name tells us, the securities are actively sold or purchased to ensure maximum returns to an investor.
  • Passive Portfolio Management: In this there is a permanent portfolio intended to match the current market situation.
  • Discretionary Portfolio management: In Discretionary portfolio management services, a person sanctions a portfolio manager to take care of his financial needs on his behalf. The term “discretionary” indicates the fact that the investment decisions will be made with the portfolio manager’s choice. The individual provides money to be invested to the portfolio manager who in return takes care of all his investment needs, paperwork, documentation, filing and so on. In discretionary portfolio management, the portfolio manager has full rights to take decisions on his client’s behalf. Discretionary investment management is generally only offered to high net worth clients who have a significant level of investable assets.
  • Non-Discretionary Portfolio management services: In non-discretionary portfolio management services, the portfolio manager advice what is good and what is bad but cannot and will not take decisions on behalf of the client.

    portfolio optimizationPicture Credit: thestateinvestor.wordpress.com
    Picture Credit: thestateinvestor.wordpress.com portfolio optimization

How to construct an efficient portfolio?

Portfolio optimisation is a mathematical structure for deciding investment of financial assets. It helps to determine the right proportion of choosing various assets in a portfolio, so as to make the proportion better. It considers the rate of return, the rate of dispersion and other financial risks.

  • Modern Portfolio Theory (MPT): The father of the Modern portfolio theory (MPT) is Harry Markowitz. According to the modern portfolio theory, it is possible to construct an efficient frontier of optimal portfolios, which can offer a maximum rate of return for a particular level of risk. By investing in more than one stock the investor can reap huge benefits of diversification leading to decrease in the level of riskiness. This can be known as not putting all your eggs in one basket as MPT quantifies the benefits. Because of these investors are faced with huge trade-offs between the returns expected and the risks.
  • The Mean-Variance Theorem: In MPT, also known as mean-variance theorem, the risk is measured by the standard deviation of the rate of return. There are several methods for portfolio optimisation. Different methods measure the risks differently.

What is the procedure for optimization of a portfolio?

Most of the times optimisation of portfolio is done in two stages:

  • Optimising of weights of asset classes to be held
  • Optimising weights within the same asset class.

This two-step procedure helps to eliminate non-systematic risks both on the individual asset and the asset class level.

How can be the Optimisation of Portfolio conducted?

Generally, portfolio optimisation is conducted under the limitations which may include lack of liquid market, some regulatory constraints etc. this leads to the application of extreme weights which focuses on small sub-samples of assets within the portfolio. The under-diversified portfolio is a resultant of constraints like taxes, transaction costs etc.

Since all this is a tedious task, the computations, finding out the complexity of tasks are done by computer. Essential to this optimization is the building up of the covariance matrix considering the rates of return on the assets in the portfolio.

Which mathematical tools can be used for the portfolio optimisation?

The Mathematical tools used for the portfolio optimization are:

  • Quadratic programming
  • Nonlinear programming
  • Mixed integer programming
  • Meta-heuristic methods
  • Stochastic programming

Portfolio optimization assumes the investor may have some risk-aversion and the stock prices may display substantial dissimilarities between their historical or forecast values and what is experienced. In particular, financial crises are characterized by a significant increase in correlation of stock price movements which may seriously degrade the benefits of diversification.

Why take up Portfolio Management?

The major benefits of taking up Portfolio Management are:

  • Managing an environment which has combined decisions related to investment is easier
  • The risks get minimized as compared to the individual projects
  • Making sure all the resources are utilized to the optimum
  • Consideration of the profits not only for the present as well as the future