08) Financial Concepts: The Optimal Portfolio

by · October 6, 2010

This concept is under the modern portfolio theory which assumes that investors would always try to reduce risk while waiting to strike the highest return possible. The theory states that investors behave rationally, in that they make decisions that will maximize their return at a risk level acceptable to them.

This portfolio type was used by Harry Markowitz in 1952 which shows that it is possible for different portfolios to have different levels of risk and return. Investors first decide on how much risk they can handle and from there, diversify or allocate their portfolio based on this decision.

In a risk and return curve, an optimal-risk portfolio is said to be somewhere in the middle of the curve. Going higher up the curve will only take on more risk for a lower incremental return. At the bottom of the curve are the low risk/low return portfolios which are pointless. The same result can be achieved by investing in risk-free assets like government securities.

In the efficient frontier, this allows you to choose how much volatility you can handle, which gives you the maximum return for the amount of risk you want to accept. For this, computer applications help you optimize your portfolio. A number of applications have been developed to simulate hundreds to thousands of different expected returns for each given amount of risk.