How can we arrive at the optimal portfolio

To balance theory with practice is a differentiator for aspiring portfolio managers. Keep reading to learn more. An ad-free and cookie-free website. Understanding the Optimal Portfolio Theory of Investments Intermediate Optimal portfolio is a term used in portfolio theory to refer to the one portfolio on the Efficient Frontier with the highest return-to-risk combination given the specific investor's tolerance for risk. Synonym: Optimal Set For context, it is important to remember that 'optimal' refers to the one best solution based on numerous estimates derived from the past.

In a Sentence Doc: The theoretically optimal portfolio is often based on estimates using data from historical periods. Optimal Portfolio definition for investment modeling Video Script The script includes two sections where we visualize and demonstrate the concept of the Optimal Portfolio. Visualize We're sitting in Excel and this is a snippet from our boot camp course Quant Demonstrate Let's demonstrate this by talking about two points on the Indifference Curve and thinking about the word indifference.

Quiz Click box for answer. The Optimal Portfolio should be considered a preliminary portfolio because it is based on estimates. True or False? True The numerator in the function that derives the optimal portfolio weights to securities is portfolio variance.

It is the array of expected returns. Questions or Comments? Related Terms Our trained humans found other terms in the category Modern Portfolio Theory you may find helpful. What's Next? To see all terms in the Glossary, click Outline. To learn about the Opportunity Set, click Back. If you support quality sign-up-free content, click Tip. Measure content performance. Develop and improve products. List of Partners vendors.

The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal because they do not provide enough return for the level of risk. Portfolios that cluster to the right of the efficient frontier are sub-optimal because they have a higher level of risk for the defined rate of return.

The efficient frontier theory was introduced by Nobel Laureate Harry Markowitz in and is a cornerstone of modern portfolio theory MTP. The efficient frontier rates portfolios investments on a scale of return y-axis versus risk x-axis. The compound annual growth rate CAGR of an investment is commonly used as the return component while standard deviation annualized depicts the risk metric. The efficient frontier graphically represents portfolios that maximize returns for the risk assumed.

Returns are dependent on the investment combinations that make up the portfolio. A security's standard deviation is synonymous with risk. Ideally, an investor seeks to fill a portfolio with securities offering exceptional returns but with a combined standard deviation that is lower than the standard deviations of the individual securities.

The less synchronized the securities lower covariance , the lower the standard deviation. If this mix of optimizing the return versus risk paradigm is successful then that portfolio should line up along the efficient frontier line.

A key finding of the concept was the benefit of diversification resulting from the curvature of the efficient frontier. It also reveals that there is a diminishing marginal return to risk. Adding more risk to a portfolio does not gain an equal amount of return—optimal portfolios that comprise the efficient frontier tend to have a higher degree of diversification than the sub-optimal ones, which are typically less diversified.

The efficient frontier and modern portfolio theory have many assumptions that may not properly represent reality. For example, one of the assumptions is that asset returns follow a normal distribution. In reality, securities may experience returns also known as tail risk that are more than three standard deviations away from the mean.

Consequently, asset returns are said to follow a leptokurtic distribution or heavy-tailed distribution. Additionally, Markowitz posits several assumptions in his theory, such as that investors are rational and avoid risk when possible, that there are not enough investors to influence market prices, and investors have unlimited access to borrowing and lending money at the risk-free interest rate.

However, reality proves that the market includes irrational and risk-seeking investors, there are large market participants who could influence market prices, and there are investors who do not have unlimited access to borrowing and lending money. One assumption in investing is that a higher degree of risk means a higher potential return. Conversely, investors who take on a low degree of risk have a low potential return.

According to Markowitz's theory, there is an optimal portfolio that could be designed with a perfect balance between risk and return. The optimal portfolio does not simply include securities with the highest potential returns or low-risk securities. The optimal portfolio aims to balance securities with the greatest potential returns with an acceptable degree of risk or securities with the lowest degree of risk for a given level of potential return.

The points on the plot of risk versus expected returns where optimal portfolios lie are known as the efficient frontier. Assume a risk-seeking investor uses the efficient frontier to select investments. The investor would select securities that lie on the right end of the efficient frontier. As you decide how to allocate your portfolio, you might choose one of several basic allocation strategies.

Each offers a different approach based on the investor's time frame, goals, and risk tolerance. When your portfolio is up and running, it's important to conduct a periodic review.

That includes a consideration of how your life and your financial needs have changed. Consider whether it's time to change the weighting of your assets. Even if your priorities haven't changed, you may find that your portfolio needs to be rebalanced. That is, if a moderately aggressive portfolio racked up a lot of gains from stocks recently, you might move some of that profit into safer money market investments.

Asset allocation is a fundamental investing principle that helps investors maximize profits while minimizing risk. The different asset allocation strategies described above cover a wide range of investment styles, accommodating varying risk tolerance, time frames, and goals.

When you've chosen an asset allocation strategy that's right for you, remember to review your portfolio periodically to ensure that you're maintaining your intended allocation and are still on track for your long-term investment goals. Portfolio Management. Portfolio Construction. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.

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Your Money. Personal Finance. Your Practice. Popular Courses. Investing Portfolio Management. Table of Contents Expand. What Is Asset Allocation? Deciding What's Right for You. A Conservative Portfolio.

A Moderately Conservative Portfolio. A Moderately Aggressive Portfolio. An Aggressive Portfolio. A Very Aggressive Portfolio.

Tailor Your Allocations. Maintaining Your Portfolio. The Bottom Line. Key Takeaways Your ideal asset allocation is the mix of investments, from most aggressive to safest, that will earn the total return over time that you need. The mix includes stocks, bonds, and cash or money market securities.

The percentage of your portfolio you devote to each depends on your time frame and your tolerance for risk. This isn't a one-time decision. Revisit your choices from time to time to see if it is still meeting your needs and goals.

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