When you read something like Optimal Portfolio, the first thing that would strike you will be a highly esoteric financial concept that is out of bounds to the understanding of most people. However, that is not necessarily the case. The concept of optimal portfolio is extremely simple and something that we all apply in our daily lives. Of course, we do it intuitively without realizing it.
Chart Source: Investopedia
The outer limits of optimal portfolio
So, what do you understand by optimal portfolio? What are the characteristics of an optimal portfolio and how to create an optimal portfolio? But, first what is the concept of optimal portfolio all about? An optimal portfolio is one that minimizes your risk for a given level of return or maximizes your return for a given level of risk. What it means is that risk and return cannot be seen in isolation. You need to take on higher risk to earn higher returns. If you look at the graphic above, there is a clear positive relationship between risk and return. Higher the risk taken higher is the return expectation and lower the risk taken; the lower is the return expectation. When you are selecting an investment portfolio for yourself, you always try to ensure that your portfolio lies along this frontier. If your portfolio is below the curve then it means you are not getting adequate return for the risk taken. If it is above the curve then it means you are getting more returns than justified by risk. That kind of situation is not sustainable and you need to be wary of such portfolios.
The risk-return matrix and the optimal portfolio
How does a risk-return matrix come about? Broadly there are 5 levels of risk in any investment viz. time value risk, interest rate risk, default risk, market risk and asset level risk. Let us look at each one of them individually.
The most basic form of investment is the government Treasury Bills or call money which has only time value risk. So you just get compensated for the time value and they have the lowest level of risk and the lowest returns.
Slightly above that on the risk scale are the government bonds that are long term in nature. There is no default risk here as governments don’t default on debt. However, if the interest rates go up, the price of these bonds will go down. So they expect compensation for this risk.
Then we have private bonds and corporate bonds that are also subject to default risk and hence they will require higher level of returns compared to government bonds. They are higher on the risk and return scale.
Higher than these fixed income instruments, we have index funds and index equities which also carry market volatility risk. Index funds require higher returns compared to any form of fixed instruments.
Finally, we have diversified equity funds and sectoral funds which run risks that are specific to a sector, company or an asset class. These asset classes, therefore, call for the highest level of returns.
Putting all the pieces together to understand an optimal portfolio
In this discussion, we are not talking about specific asset classes like equity, debt and gold but we are talking about portfolios. Remember, portfolios are combinations of assets. For example, a portfolio consisting of 70:20:10 in equity, debt and liquids may be a high risk portfolio at the upper end of the curve. On the other hand, a portfolio mix of 20:40:40 will be an extremely conservative portfolio and will be at the lower side of the curve. How your portfolios are mixed up will determine which part of the curve your portfolio will be in. As long as your portfolio falls on the curve it is an optimal portfolio. The mismatch in your portfolio arises only when it is above or below the curve.
What does optimal portfolio ultimately boil down to?
At the end of the day, if you remove all the glitz, the optimal portfolio basically tells us that if you expect more returns then you must be willing to take on more risk. However, higher risk by itself is not a guarantee of higher returns. Risk taking, therefore, has to be calibrated and measured. That is one of the best cases in favour of buying equities for the long run!