Constructing an optimal Portfolio

The idea of an “optimal portfolio” comes from the modern portfolio theory. Among other things, this theory assumes that investors focus their efforts on minimizing risk while also striving to attain the highest possible return. According to this theory, investors will act rationally within these parameters, and that they will always make decisions with the goal of maximizing return for a given acceptable level of risk.

Harry Markowitz introduced the idea of the optimal portfolio in 1952. This model shows that it is possible for different portfolios to have different levels of risk and return. This means that individual investors should determine how much risk they are willing to take on, and then they can allocate or diversify their portfolios according to the results of that decision.

The chart below is an illustration of the optimal portfolio concept. An optimal-risk portfolio is typically somewhere in the middle of the curve, owing to the fact that the higher you go up the curve, the greater the proportion of risk you take on to the potential of return. On the other end, low risk/low return portfolios are generally considered a waste of time, as one can achieve a similar return by simply investing in risk-free securities and assets, like government treasuries.6.1 concepts7_optimal_portfolio.gif

An individual investor can determine how much volatility he or she is willing to maintain in his other portfolio by picking another point which lies along the so-called efficient frontier. Doing so will provide maximum return for the amount of risk that the investor has decided to accept. Of course, optimizing a portfolio in practical terms is quite difficult and cannot be done easily. Today, there are computer programs and services which are devoted to determining optimal portfolios. The way that they accomplish this is by estimating different expected returns thousands of times over for each amount of risk.

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