“But divide your investments among many places, for you do not know what risks might lie ahead.” - Ecclesiastes
You’ve explored the meetinvest stock screening tool and now have a list of stocks that you are thinking of investing into. You’ve digested the information on our Insights section and understand the importance of Diversification within your portfolio. You feel ready to get investing but something stops you in your tracks.
Exactly how much money should I now allocated to each stock on my list of stocks? Should I spread the money equally across each stock, or place more weight on certain stocks, or what? How can I be sure that my portfolio is optimized?
To aid you with finding these answers, we have created the meetinvest portfolio optimization tool that helps you find out on how best to optimize your portfolio so that you can understand how to spread your money across stocks.
In the early 1950s, while researching portfolio optimization techniques for his dissertation at the University of Chicago, eventual Nobel Prize winner Harry Markowitz applied mathematics to his analysis of the stock market. He wanted to develop an algorithm that could identify the optimal portfolio for any selected list of stocks.
By creating different portfolios with different stock weights and testing his optimization techniques, Markowitz found out that the best combinations are displayed on a line in a graph that looks like the nose of a high-speed train from the side (see below).
Markowitz called this line the ‘efficient frontier’, where all efficient (best) portfolio combinations are found (It is indicated below with a blue line), with each red point on the graph representing a portfolio consisting of all or some of a particular stock from a list, but with a different stock percentage mix.
To illustrate, assuming you have created a list of 25 promising stocks from one or more of the meetinvest guru strategies and one of these 25 shortlisted stocks is Apple (APPL). If you were using the Markowitz’s optimizer (which runs thousands of different stock combinations), the Apple stock in a particular portfolio could have weight 2.0% (one of the red points), while in another portfolio, this same apple stock could have weighed 4.1% (another red point).
Essentially, the ‘efficient frontier’ is where the best investable portfolios with the least amount of risks are positioned. Each such portfolio has a different percentage mix of optimized stocks.
Within the professional investment management industry, it is common practice to use one of the four standard optimization methods:
1. Conservative - least-risky (MinVar)
The first way to create a portfolio is to consider Markowitz’s initial approach. He was looking for a portfolio mix that has the least amount of risk and can be found on the very tip of the efficient frontier. This portfolio is called minimum variance (MinVar).
While MinVar optimization creates a portfolio with the least amount of expected risk, it also leads to a concentration in low volatility stocks. This simply means that the MinVar portfolio is typically more suitable for investors who wish to invest in low-risk or ‘defensive’ stocks, as these portfolios are not optimal when it comes to maximizing returns.
2. Balanced - most diversified (MaxDiv)
A second way to create portfolios aims at taking stocks that have the lowest possible correlation to each other.
An example would be buying a healthcare stock, an energy stock and a bank stock. Their business models are independent of each other within business cycles and are therefore great combinations. Such an optimization is called Minimum correlation or MaxDiv.
While this technique doesn’t necessarily maximize the expected return, it maximizes the best possible diversification and helps spread risk.
3. Dynamic - equally weighted (EqualWeight)
The simplest way to create a portfolio is to give each stock position the same percentage amount of weight. You do this by dividing 100% by the number of different stocks. Assuming you have 25 stocks on your list: divide 100% by 25, which give you 4% for each stock. Ergo, put 4% of your investment money into each of the 25 stocks.
While this method is fast and easily done, it can create portfolios that are suboptimal to say the least. Why? Let’s assume that 8 out the 25 stocks on your list fall within the energy sector and for some reason the entire energy sector experience a drop in stock prices. You would now have just taken a 32% or 1/3 of your portfolio loss. Definitely not an optimally diversified portfolio!
4. Aggressive - most dynamic (MaxSharpe)
The fourth way to create a portfolio is to maximize the return while still trying to reduce the risk as much as possible.
In finance, the so-called Sharpe ratio (named after its creator Nobel laureate William F. Sharpe) measures the excess return (or risk premium) per unit of risk of an investment.
The Sharpe ratio is calculated as: (Return − Risk-free rate)/Standard deviation. By subtracting the risk-free rate from the return, the performance associated with risk-taking activities can be isolated.
Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return. Essentially, the maximum Sharpe optimization aims to find a good portfolio mix that primarily maximizes the return for the lowest possible risk.
To illustrate the different ways a portfolio can be optimized, here a back-test of the Dow Jones Index using the four different portfolio optimization techniques introduced above. The following performance graph shows the results of these back-tests. Look at black, green, marine-blue and pink:
Now let us quantify the different approaches by looking at some important key figures and costs that can eat into your wallet:
Portfolio Turnover (that generates costly commissions)
If you are aiming for the Conservative portfolio you have to be aware that the portfolio turnover will be amongst the highest with commissions eating into your performance. The reason for this is the constant change of volatility (extent of the price fluctuation).
The Dynamic or Balanced portfolios are much more cost-conscious.
Price fluctuation (Volatility)
Not surprisingly, the Conservative portfolio has the lowest price fluctuation followed by the Balanced. The Dynamic and Aggressive are expected to have the highest portfolio price fluctuations.
Portfolios with a lower level of risk also have a lower expected return, the Conservative in particular. The other three portfolios have a somewhat similar expected outcome.
When it comes to investing our money, we at meetinvest use a portfolio optimizer. As an investor you’ll need to decide which is best for you. Which method you select depends on your risk-reward appetite. It’s up to you to decide what’s most suitable for you.