Portfolio optimisation: 4 strategies to achieve the best balance between risk and return

In the investment world, one of the main objectives is to achieve maximum return with minimum risk. However, this is no easy task, as risk and return are closely linked. In most cases, the rule is that the higher the potential return, the higher the associated risk.

Portfolio optimisation is the process whereby an investor seeks to find the best balance between risk and return, taking into account their investment objectives, risk tolerance and time horizon. It is like putting together a jigsaw puzzle where each piece is important and the right placement gives the best result.

In this article, we dive into the world of portfolio optimisation. We'll explore why optimisation is important, how to do it and what tools to use. We will also discuss aspects of behavioural finance and share practical tips.

What is investment portfolio optimisation and why is it important?

Portfolio optimisation is a mathematical and strategic process that aims to find the best possible allocation between assets, taking into account the risk tolerance and return expectations of a particular investor. In simple terms, it is finding a balance between maximum return and minimum risk. Portfolio optimisation is based on modern portfolio theory (MPT) principles, whereby it is not the performance of individual investments that matters, but the risk and return of the portfolio as a whole. This means that the correlation between different assets should be taken into account when selecting the composition of a portfolio. A well-optimised portfolio will therefore be diversified, including different asset classes such as equities, bonds, real estate and alternative investments that react differently to market events. Optimisation is an ongoing process that requires regular review and, where necessary, changes to ensure that the portfolio continues to meet the investor's objectives and market conditions.

Portfolio optimisation can help you:

Achieve your investment goals: Whether it's saving for retirement, buying a home or simply growing wealth.
Reduce risk: By spreading your investments across different asset classes, you can reduce the overall risk of your portfolio.
Increase returns: An optimised portfolio will give you the best possible return at your chosen risk level.
Maintain a calm mind: Knowing that your portfolio is optimised means you can sleep easier, even when markets are volatile.

Different asset classes: Risk and return

Different asset classes have different levels of risk and return potential.

Shares: They offer potentially high returns, but are also riskier.
Bonds: They are generally less risky than equities, but also offer lower returns.
Real estate: It offers stable returns and inflation protection, but is less liquid.
Raw materials: They can offer high returns but are highly volatile.

The risks and returns of asset classes are correlated. For example, equities and bonds are usually negatively correlated, which means that when equity markets fall, bond prices rise. Therefore, having both equities and bonds in a portfolio helps to diversify risk and optimise returns.

Optimisation strategies

Portfolio optimisation strategies are diverse and can be tailored to individual needs and market conditions.

Regular rebalancing of the portfolio (rebalancing): This is one of the simplest and most important strategies. Rebalancing the portfolio means restoring the proportions of the asset classes originally set. For example, if the value of equities has risen significantly, they make up a larger proportion of the portfolio than originally planned. Rebalancing involves selling some shares and using the proceeds to buy other assets, such as bonds, to bring the portfolio back into line with the original strategy. This helps to keep risk at the desired level and avoid excessive exposure to one asset class.
Cost-neutrality: As investment fees can have a significant impact on the final return over the long term, it is important to optimise the costs of the portfolio. This means giving preference to index funds and ETFs (Exchange Traded Funds), which have low management fees, over actively managed funds, which often have significantly higher fees.
Bond laddering strategy (bond laddering): This strategy is particularly well suited to optimising sustainable income. It involves the purchase of bonds with different redemption dates, spread out over time. When a bond matures, its principal is reinvested in a new bond with a longer maturity. This helps to mitigate the risk of changes in interest rates, as part of the portfolio is regularly renewed on the basis of prevailing market conditions.
Holistic risk management: In addition to the risks of individual asset classes, it is also important to take into account the impact of macroeconomic risks, inflation and exchange rates. When optimising the portfolio, consideration should be given to diversifying assets across geographical regions and industries to reduce the impact of local crises.

These strategies provide investors with tools to help them consistently build their portfolio and achieve their goals. Optimisation is not a one-off exercise, but an ongoing, conscious process that is the foundation of successful investing.

Portfolio rebalancing: Maintaining the desired risk level

Rebalancing the portfolio means adjusting the portfolio on a regular basis in order to maintain the desired asset allocation. For example, if stock markets have risen and the proportion of shares in your portfolio has increased, you can sell some shares and buy bonds to restore the original allocation. This will help you control the risk and volatility of your portfolio.

There are different rebalancing strategies:

Calendar-based rebalancing: The portfolio is adjusted at specific points in time, for example quarterly or annually.
Threshold-based rebalancing: The portfolio is adjusted when the asset weightings have deviated from certain thresholds.

There are also costs and fees associated with rebalancing, such as transaction fees. It is therefore important to consider the frequency of rebalancing and to choose the strategy that suits you best.

Behavioural finance: the impact of emotions on investment decisions

Investment decisions are not always made rationally. Investors' emotions and cognitive biases can influence portfolio optimisation and lead to sub-optimal outcomes.

For example:

Hirm: During a market downturn, investors may panic and sell their investments, realising losses.
Ahnus: In a rising market, investors may buy overpriced shares in the hope of making a quick profit.
Confirmation bias: Investors tend to look for information that confirms their existing beliefs and ignore information that contradicts them.

Knowledge of behavioural finance helps investors avoid emotional decisions and make rational investment choices.

Practical tips to optimise your portfolio

Here are some practical tips to help you optimise your portfolio:

Define your investment objectives and risk tolerance.
Choose the right asset classes and diversify your investments.
Use effective frontier analysis to find the optimal shadow distribution.
Rebalance your portfolio regularly.
Monitor your portfolio and make changes if necessary.
Avoid emotional decisions and make rational investment choices.
Use portfolio optimisation tools and resources.
If necessary, consult a financial adviser.

Tools and resources

There are a number of useful tools and resources to optimise your portfolio:

Web calculators: Help you calculate portfolio returns, risk and diversification.
Software programmes: Offer more sophisticated analysis and optimisation capabilities.
Online resources: Provide information on investing, portfolio optimisation and behavioural finance.

Some examples:

Portfolio Visualizer: www.portfoliovisualizer.com
Morningstar: www.morningstar.com
Investopedia: www.investopedia.com

Summary

Portfolio optimisation is an important process to help you achieve your investment goals and secure a more secure future. It requires knowledge, time and patience, but it is well worth the effort.