# What do we understand by an optimal portfolio?

October 13, 2021

**What do we understand by an
optimal portfolio?**

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.

**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:

1. Time
value risk,

2. Interest
rate risk,

3. Default
risk,

4. Market
risk and

5. 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 donâ€™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!

Source: motilaloswal.com

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