It may seem like with your list of assets growing and growing you’re never going to be able to fully optimize your portfolio.
You want to do a better job of tracking the performance of different investments and optimizing for ROI, but self-managing a diverse investment portfolio to achieve its best balance is practically a full time job.
Unless you have the right knowledge and tools for the job.
In the article, not only are we going to help you learn the important history of portfolio optimization, we’re also going to teach you the core elements of portfolio optimization, some achievable tactics for finding balance, and how to automate tracking your ROI across various investments so you can focus on what matters — optimizing your portfolio to maximize expected returns.
Modern Portfolio Theory: The Origin of Maximizing Returns and Minimizing Risks
If you truly want to understand the value of portfolio optimization you have to understand what underpins it — the grandfather of all of today’s investing methodologies: modern portfolio theory.
Modern portfolio theory (MPT) argues that, for the most part, investments can be high risk/high reward or low risk/low reward. So, in order to minimize risk and maximize returns, investors should choose a mix of investments of both types, in line with their personal risk tolerances.
While it seems like an obvious concept today, this was groundbreaking for personal investing when economist Harry Markowitz introduced it in the paper Portfolio Selection, published in 1952 (he eventually earned a Nobel Prize related to his work on MPT!).
This idea that portfolio diversification — something we’ll talk about more later — would create better returns than a portfolio full of only low-risk investments seemed counterintuitive to investors of the time. But, as we’ve since seen, Harry’s theory proved true.
Portfolio Optimization: A Tightrope Walk for Today’s Investors
The topic of today’s article, portfolio optimization, takes MPT a step further. With portfolio optimization it’s about more than general diversification, it’s about focused diversification by way of careful asset selection.
Portfolio optimization is a process in which an investor chooses their assets to optimize on one or more specific objectives. Typically, these objectives include minimizing financial risk and maximizing financial return — the perpetual tightrope walk with which every investor has become familiar.
The core elements that anyone trying to optimize their portfolio needs to know include:
Portfolio Return on Investment
Return on investment (ROI) is a metric with which you’re likely familiar, as it’s nearly universal across all industries.
In fact, it’s a key element for determining how well an overall portfolio as well as the individual assets within it are performing. ROI uses a simple algorithm to compare the current worth of an investment against its original worth (aka what you paid for it) to determine whether it’s grown or shrunk in value.
ROI is usually used to compare and rank different assets in order of attractiveness and priority.
Usually, the higher the ROI, the better. Of course, higher return is often correlated with higher risk. That brings us to the next factor of effective portfolio optimization: risk.
In financial terms, risk is the possibility that an investment’s returns will differ from what’s expected.
No matter how we tend to think of it, risk isn’t inherently bad or something that should be avoided at all costs. When it comes to investing, risk can be thought of as a resource. Exposure to this resource generates returns — or rewards in return for taking on uncertainty.
Portfolio risk is the sum of the risk associated with each individual asset in a portfolio. The risk in a portfolio can be controlled, to some extent, by asset allocation. Investing in more risky assets (think volatile NFTs) will increase your overall portfolio risk. Outside of asset allocation, market changes are the other single biggest factor in portfolio risk.
Promised we’d circle back to portfolio diversification!
Portfolio diversification is when an investor takes on uncorrelated asset types within a single portfolio.
A portfolio with diverse, uncorrelated assets won’t be as impacted when world events cause the value of huge publicly-traded companies and the stock market to take a swing. This helps prevent permanent capital loss. And, with time, diversification has been found to improve returns and minimize risk.
In this way, diversification can be viewed as a type of risk management strategy that helps portfolios weather any storms that asset and market fluctuations throw their way.
With careful diversification that takes asset risk and ROI into account, portfolio optimization can be achieved.
Tips for Achieving Your Optimal Portfolio Balance
As mentioned, it can be a tightrope act when it comes to portfolio optimization. Here’s how to strike that perfectly-diversified balance and overcome any optimization problems.
Determine Your Goals
We say this all the time but, first and foremost, if you want your portfolio to get you somewhere you have to define where that somewhere is.
Building up a high-return portfolio that aligns with your ideal risk profile isn’t going to just happen. You need a goal to aim for to motivate you to make it a reality.
Your goal can be far off — retirement is a common one. Or your goal can be more near-term — like a real estate purchase or a long vacation.
Of course you can have multiple goals, but we recommend prioritizing them and not having more than you can quickly remember off the top of your head.
No investments should be made without these goals in mind, and you should be optimizing your portfolio regularly according to your goals.
Know Your Risk Tolerance — And How It Should Change Over Time
We’ve talked about your comfort level with risk a few times, so let’s flesh out that concept further.
Risk tolerance accounts for how much you can afford to lose financially and how much volatility you can handle psychologically. In order to build out and truly optimize an investment portfolio, you need to have a good understanding of the level of risk you’re willing to tolerate.
Tolerance usually falls into three general buckets: low, moderate, and high. High-tolerance investors, meaning those who can mentally and financially handle a decent level of loss, are typically 20+ years away from retirement. Younger investors generally have higher risk tolerances simply because they have more time before retirement to earn back big capital losses. The closer an investor gets to retirement or income loss for any reason, the more risk aversion they usually adopt.
The best way to define your risk tolerance is to speak with a financial professional who’s well versed in answering these kinds of questions for investors. There are also a lot of risk tolerance calculators available online. When computing your risk tolerance, consider things like current portfolio value, investing timeline, monthly income and expenses, how much you can afford to lose, and how well you cope with financial loss.
Your risk tolerance will of course play a huge role in which kinds of assets you take on in your quest for portfolio optimization. Don’t forget to check on your risk tolerance from time to time, as it should definitely shift as you get older and as any major financial changes occur in your life.
With your risk tolerance and ROI goals in mind, you might want to try asset weighting as an objective approach to portfolio optimization.
Asset weighting is the practice of assigning a weight to each asset class. The weight is the percentage of your portfolio that’s made up of that asset class. So if 25% of your portfolio is in stocks, the weight of your stocks asset class is 25%.
You can also weight individual assets within asset classes. So if 60% of your stocks asset class is fast-growth stocks and the other 40% is slow-growth stocks, those are the respective weights for each of those specific asset types.
The point of determining optimal weights is to create a clear picture of what’s working, and what isn’t, in what percentage for your portfolio, so you can prioritize asset allocation. When you realize that the majority of your stock weight concentration is in the fast-growth category, you know to focus your investment dollars there before slow-stocks to stay aligned with your ROI goals and risk tolerance parameters.
If you need some assistance choosing asset allocation based on your risk tolerance, a digital calculator can help.
Get Familiar With Your Holdings
Somewhat of a “soft skill” that not many investors talk about is getting to know the industries and businesses that surround the holdings in your portfolio.
For example, knowing about the automotive industry might not exactly get you insider knowledge, but it can give you some peace of mind around whether or not investments in Toyota, Ford, and so on will generate the ROI you’re looking for at an acceptable risk level.
Optimize Your Portfolio in One Place with Kubera
You must understand the ROI of your various assets to effectively rebalance your assets and optimize return vs. risk.
Who has the time, the patience, or even all the information needed to find the ROI of every. single. asset. In their portfolio? And then keep that ROI up to date as the value of each asset changes?
Don’t skimp on portfolio optimization just because you don’t have time.
Kubera automates the process of finding ROI for your various investments, so you can finally optimize your portfolio based on performance.
Finding and monitoring internal rate of return — IRR for investments is a more detailed version of ROI — across a portfolio with a number of assets including stocks, Fiat currency, valuables, bank accounts, cryptocurrency, NFTs, and more is complex.
Which is why we added a feature to Kubera’s personal balance sheet software that enables you to do it automatically.
For account-based assets, Kubera instantly keeps all your asset details up to date (check out our How Kubera Works page to see it in action). But for any assets that aren’t totally up to date, the first step to finding IRR is using Kubera’s modern interface to add asset details like cost, value, and cash flow.
Kubera applies these details, and rolls in holding time, to display the IRR of any asset — in your preferred currency!
Kubera even displays the IRR of popular indices and tickers (like the S&P 500 and Tesla) to give you insight into how your assets are performing and if it’s time to double-down on or ditch certain holdings.
Read our IRR help center article to see Kubera’s IRR calculator at work.
In addition to our IRR calculator and easy-to-use portfolio tracker interface, we’ve also built in integrations with tools like Zillow and EstiBot. These give investors real-time data on the value of key asset types, like real estate, web domains, and more.
Now for the pièce de résistance when it comes to portfolio optimization: the net worth recap visualization.
With recap, Kubera crunches all the data in your portfolio to show asset performance and net worth growth on a daily, weekly, monthly, quarterly, and yearly basis. You’ll know instantly when your optimization efforts are up to snuff.
Achieve balanced portfolio management without sacrificing your sanity when you sign up for your Kubera subscription today.
Work with a financial advisor, wealth manager, or another type of investment professional? You can still use Kubera with their guidance when they use our white-label solution as part of their employee portal. All they have to do to adopt Kubera and start attracting Millennial, Gen Z, and other tech-savvy client types is request a demo now.