1. Financial Concepts: Introduction
  2. Financial Concepts: The Risk/Return Tradeoff
  3. Financial Concepts: Diversification
  4. Financial Concepts: Dollar Cost Averaging
  5. Financial Concepts: Asset Allocation
  6. Financial Concepts: Random Walk Theory
  7. Financial Concepts: Efficient Market Hypothesis
  8. Financial Concepts: The Optimal Portfolio
  9. Financial Concepts: Capital Asset Pricing Model (CAPM)
  10. Financial Concepts: Conclusion

The idea of an “optimal portfolio” comes from the modern portfolio theory. Among other things, this theory assumes that investors focus their efforts on minimizing risk while also striving to attain the highest possible return. According to this theory, investors will act rationally within these parameters, and that they will always make decisions with the goal of maximizing return for a given acceptable level of risk.

Harry Markowitz introduced the idea of the optimal portfolio in 1952. This model shows that it is possible for different portfolios to have different levels of risk and return. This means that individual investors should determine how much risk they are willing to take on, and then they can allocate or diversify their portfolios according to the results of that decision.

The chart below is an illustration of the optimal portfolio concept. An optimal-risk portfolio is typically somewhere in the middle of the curve, owing to the fact that the higher you go up the curve, the greater the proportion of risk you take on to the potential of return. On the other end, low risk/low return portfolios are generally considered a waste of time, as one can achieve a similar return by simply investing in risk-free securities and assets, like government treasuries

 

 

An individual investor can determine how much volatility he or she is willing to maintain in his other portfolio by picking another point which lies along the so-called efficient frontier. Doing so will provide maximum return for the amount of risk that the investor has decided to accept. Of course, optimizing a portfolio in practical terms is quite difficult and cannot be done easily. Today, there are computer programs and services which are devoted to determining optimal portfolios. The way that they accomplish this is by estimating different expected returns thousands of times over for each amount of risk.


Financial Concepts: Capital Asset Pricing Model (CAPM)
Related Articles
  1. Managing Wealth

    Achieve Optimal Asset Allocation

    Minimize risk while maximizing return with the right mix of securities and achieve your optimal asset allocation.
  2. Investing

    How to Create a Low-Risk, High-Return Portfolio

    Modern portfolio theory states diversification will create a lower-risk, higher-return portfolio.
  3. Investing

    Explaining The Efficient Frontier

    Most investment choices involve a tradeoff between risk and reward. The "Efficient Frontier" is a modern portfolio theory tool that shows investors the best possible return they can expect from ...
  4. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in modern portfolio theory to quantify investment risk.
  5. Investing

    How to Create a Risk Parity Portfolio

    Learn about how risk parity uses leverage to create equal exposure to risk among different asset classes in portfolio construction.
  6. Financial Advisor

    Measure Your Portfolio's Performance

    Measuring the success of your investment solely on the portfolio return may leave you blindsided to risk. Learn how to evaluate your investment return.
  7. Financial Advisor

    4 Steps to Building a Profitable Portfolio

    This is a step-by-step approach to determining, achieving and maintaining optimal asset allocation.
  8. Investing

    Two Approaches to Building a Low-Risk Portfolio

    Building a portfolio consisting of low-risk assets is achieved primarily by using one of two principal low-volatility strategies.
Trading Center