Updated: Mar 14
Break intuitions and hop-in to optimism
To create an Optimal Portfolio one of the main aspects is Risk Diversification. It can be achieved by using some technical ideologies.
Optimal portfolio is a term used to refer Efficient Frontier with the highest return-to-risk combination given the specific investor's tolerance for risk.
In this materialistic world, many people tend to invest and make money out of it. To break out of this competition we need to be unique and our work should be exceptionally good. So, what are the things that need to be done in order 'to stand out of the crowd'? The answer is to create an Optimal Portfolio. This can be done by implementing some technical ideologies. Let's look at what are the technical terms required to satisfy the best Optimal Portfolio.
Eggs In One Basket
It's a famous phrase often used in the financial world to describe Diversification. So, what does Diversification means?
Diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. Diversification helps to reduce risk or volatility by investing in variety of assets.
Diversification is an alternative to insurance. It's the idea of managing not through purchasing an insurance policy but through owning a variety of assets. Coming to the next question 'Why is it important ?' Any level of Diversification will reduce portfolio standard deviation and will mean the Diversified portfolio's risk-adjusted return will be better than the normal weighted average risk-adjusted return. So, it is important to do Diversification. But it's all an assumption. You might have a doubt 'If I can quantify the risk and returns, I can arrive at the optimum level. Then why is it different from person to person ?' Well, it is because you might be more risk-averse than others. You might have a greater or lesser tolerance for risk. So what you would care about is the mean and variance of the return on your entire portfolio than on a particular segment. It's all about your intuition and perception.
Capital Asset Pricing Model (CAPM)
CAPM is a model used to determine theoretically a required rate of return of an asset.
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk, expected rate of return, and Cost of capital for assets, particularly stocks. In CAPM investors hold a huge diversified portfolio to reduce. The CAPM gives investors a simple calculation that they can use to get a rough estimate of the return that they might expect from an investment versus the risk of the outlay of capital. You figure out the expected return of an asset by multiplying the potential outcomes by the chances that they will occur.
Understanding CAPM Model
For example, imagine an investor is thinking of stock worth $100 per share today. The stock has a beta compared to the market of 1.3, which means it is riskier than a market portfolio. Also, assume that the risk-free rate is 3% and this investor expects the market to rise in value by 6% per year.
ERi = 3% + 1.3 * ( 6% - 3% ) ERi = 6.9%
Efficient Portfolio Frontier
It 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.
Returns are dependent on the investment combinations that make up the portfolio. The standard deviation of security is synonymous with risk. The lower variance between portfolio securities results in lower portfolio standard deviation. Optimal portfolios that comprise the efficient frontier tend to have a higher degree of diversification. A key finding of the concept is the benefit of diversification resulting from the curvature of the Efficient Portfolio Frontier. The curvature reveals how diversification improves our portfolio. It also helps to represent the risk and standard deviation based on our investment.
Let's consider some of the special cases like I'm going to invest 100% in stocks and this will be my annual return shown in the diagram. It might be risky but will average out in long term. But people won't think that way. Instead many would prefer 25% stocks and 75% bonds. The risk is low and it has a good expected return. I could invest even 120% in stocks and -20% in bonds. In this case, I need to short the bond market and buy stocks. People may ask is this possible? The answer is an absolute Yes because this whole thing is an assumption and we can do anything. As being an assumption you can assume anything and it gives your optimal return based on your risk and diversification. So, Efficient Portfolio doesn't care about how much we invest or what's the risk or standard deviation, it just gives you the best-optimized return from your investment. This too varies from person to person respective of the risk that the person willing to take.
Am I Optimal?
I love to explore. So, I attempted to create an Optimal Portfolio in a Virtual Trading Platform but I just ignored creating a CAPM Model and making an assumption in Efficient Frontier and all other stuff. You might ask ' Then how you build an Optimum Portfolio? ' To speak frankly, all these models and portfolio theories are considered as a formality in this real world. Instead, there is an ideal term or a practice called Focus Investing which is mentioned by Warren Buffett. This theory is all about picking outstanding stocks. The analytical process is way too simple. The process involves checking each opportunity against a set of investment tenets, or fundamental principles. The tenets include Business, Management, Financial and Market tenets. Following these simple steps given by the legendary investor, I built up an Optimum Portfolio. And here comes the important part, we need to diversify stocks across the sector by sector. I picked health services as a vital sector and I shorted the majority of the stocks. I did this because during this COVID 19 situation Health Services plays a major role in producing goods like masks, etc. and it won't last for the long term. Followed by Industrials, Consumer Goods, Utilities, and Technology. I've also invested in other some sectors but a very small portion. I had an underlying reason for investing in these sectors and you too should have. In two months my Return On Investment (ROI) is 6%. Despite being 15 years old, I could earn my expected returns by using simple techniques. My sincere advice is to do your practice in the virtual market before starting your investment in the real market. Go ahead, practice building an Optimum Portfolio in a virtual platform.