Portfolio optimization

Portfolio optimization is the process of constructing portfolios to maximize expected return while minimizing the risk. It involves analyzing portfolios with different proportions of investments by calculating the risk and the return for each of the portfolios and selecting the mix of investments which achieves the desired risk versus return trade off.

 

Modern portfolio theory, a hypothesis which was put forth by Harry Markowitz in 1952, assumes that an investor wants to maximize a portfolio's expected return for a given amount of risk, with risk measured by the standard deviation of the portfolio’s rate of return. The risk and return of a portfolio can be plotted on a graph as:

 

The optimal risk portfolio is usually determined to be somewhere in the middle of the curve because as you go higher up, you take proportionately more risk for a lower return, and as you go lower in the curve the portfolio returns are very low, so investing in such a portfolio would be pointless as you can achieve similar returns by investing in risk-free assets.