What is Portfolio Optimization?

Portfolio optimization is the strategy of arranging the types of financial instruments found in a given portfolio so that the best possible results are attained. Typically, this process calls for assessing several factors, including the percentage that each investment represents of the overall value of the portfolio, and the degree of financial risk associated with each holding. The optimization process also takes into consideration the goals of the investor and what combination of holdings is most likely to move the investor closer to achieving those goals.

Key to portfolio optimization is understanding what types of investments are within the scope of the investor’s comfort level. More conservative investors are likely to go with holdings that have a solid history of providing returns even in difficult economic periods. While the returns from these investments may not be spectacular, they are consistent and allow the investor to incrementally increase the overall value of the portfolio. Investors who are willing to assume more risk may be open to not only investing in emerging markets and new companies, but also taking on investments that are historically volatile, providing the opportunity to post significantly higher gains in return for assuming the greater risk.

Once the basis investment philosophy of the investor is established, the process of portfolio optimization can get underway. This will include determining the balance of assets that will be held in the portfolio. Typically, this means including holdings that are considered somewhat safe, since they help to ground the portfolio and provide a solid financial footing for the holdings. From there, the investor may choose to include assets with a slightly higher degree of risk that may be held for a time when they are posting higher returns, but are ultimately sold just before they begin to experience a downturn. Accomplishing this combination often includes buying stocks that have remained strong for a number of years, stocks that do demonstrate some volatility in different economic situations, and maybe even a few that are considered high risk.

Along with stocks, portfolio optimization may also call for including investments such as bond issues. The bonds may range from municipal bonds to treasury bills to corporate bonds, all set to mature at different times and providing varying levels of return. An investor may also choose to include mutual funds, commodities and even futures as part of the overall mix of the portfolio. As long as the particular combination is in line with the desires of the investor and represents the best possible investment options in each category, it can be said that portfolio optimization has been reached, at least until shifts in the marketplace dictate that some type of change is made in the balance between those assets.