How to Select an Optimal Portfolio

Published by under Portfolio Management

An optimal stock portfolio refers to a stock portfolio that incorporates the stocks configured in such a manner that they yield the optimal return statistically possible at a given level of risk accepted by an investor. The modern portfolio theory stresses on the optimal portfolio concept by assuming that the investors try to minimize risk obsessively while looking for the highest return possible. As per this theory, investors should make rational decisions for achieving maximum returns at their acceptable level of risk.

The working of the optimal portfolio can be easily understood by looking at the chart below. The optimal-risk portfolio is generally found in the middle of the curve. If one goes further higher up the curve, it will mean taking more risk proportionately for achieving lower incremental return. Similarly if one goes at lower end of the curve, it will mean low risk/low return portfolios.

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Risk % (Standard Deviation)

As an investor, you can select how much risk is acceptable to you in the portfolio by selecting any other point that lies on the efficient frontier. It will provide you the maximum returns for the amount of risk acceptable to you. One cannot calculate the optimization of the portfolio mentally. Investors use various sophisticated computer programs for determining optimal portfolios by estimating hundreds or thousands of different expected returns at each level of risk.

For example, if you have $10,000 to invest to build your portfolio of stocks of three companies A, B and C; then you need to decide how much money should be invested in each stock that can provide best return possible at a level of risk acceptable by you. For this, let’s create 10 random portfolios where each portfolio comprises of different proportions of the three stocks A, B and C.

The RISK/RETURN profiles of all these portfolios are mentioned in table below.

Risk Return Profile

Portfolio A B C Risk Returns

Portfolio 1 32% 38% 30% 12.10% 11.51%

Portfolio 2 68% 12% 20% 15.54% 12.76%

Portfolio 3 27% 51% 22% 12.91% 11.59%

Portfolio 4 20% 20% 60% 9.89% 11.00%

Portfolio 5 60% 20% 20% 14.86% 12.71%

Portfolio 6 12% 74% 14% 13.48% 11.22%

Portfolio 7 15% 80% 5% 14.28% 11.40%

Portfolio 8 38% 19% 43% 11.76% 11.71%

Portfolio 9 42% 19% 39% 12.05% 12.49%

Portfolio 10 74% 10% 16% 16.35% 13.06%

In this table, you can observe that each portfolio has a unique RISK/RETURN profile because of different cash/stock allocation…

Risk/Reward Profile

After the analysis of the collection of stocks, those portfolio configurations that fall on the efficient frontier are considered as optimal portfolios. The various optimal portfolios are summarised in the risk/return table. This table allows the investors to choose that optimal portfolio which provide highest return statistically possible at a given level of risk acceptable to them.

Risk /Return Table of Optimal Portfolios

Risk Returns A B C

9.0% 10.98% 10% 21% 69%

9.5% 11.21% 18% 17% 65%

10.0% 11.73% 21% 15% 63%

10.5% 11.96% 28% 14% 58%

11.0% 12.23% 22% 19% 61%

11.5% 12.61% 30% 27% 43%

12.0% 12.83% 28% 21% 50%

12.5% 12.92% 37% 12% 51%

13.0% 13.02% 30% 38% 32%

13.5% 13.12% 26% 27% 47%

14.0% 13.23% 21% 46% 33%

Thus, the optimal portfolio configuration that contains three stocks (A, B, C) is the one that gives a return higher than 11.21% at a risk of 9.50%

Optimal Portfolio

Risk Return A B C

9.5% 11.21% 18% 17% 65%

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