By Karthik Rangappa
What do you think is the overall portfolio return, considering the portfolio consists of just two stocks - Infosys and Biocon. Assume the expected return of Infosys is 22 percent and Biocon is 15 percent and they are equally weighted.
I know this sounds like a classic classroom question, but this is an important question to answer when it comes to understanding portfolio optimisation.
Since the portfolio is equally weighted across two stocks, it implies we invest 50 percent in Infosys and 50 percent in Biocon. Given this, the expected portfolio return would be –
= Weight of investment in Infosys * Expected return of Infosys + Weight of investment in Biocon * Expected return of Biocon
= 50% * 22% + 50% * 15%
=11% + 7.5%
So, the portfolio is expected to yield a return of 18.5% annually.
Great, now what if we change the weights? What if invest 30 percent in Infosys and 70 percent in Biocon? Or let us say 70 percent in Infosys and 30 percent in Biocon?
Let’s figure this out, Case 1 –
30% * 22% + 70% * 15%
= 6.6% + 10.5%
Case 2 –
70% * 22% + 30% * 15%
=15.4% + 4.5%
Needless to say, we can do this for multiple combinations of weights. In fact, here is the table with few of the other combinations possible –
As you can notice, as the investment weight varies, the returns also varies. For example, if I had decided to invest just 40 percent in Infosys and 60 percent in Biocon, I’d have enjoyed a return of 17.8 percent.
However, if I had reversed it by investing 60 percent in Infosys and 40 percent in Biocon, I’d have enjoyed a return of 19.2 percent, which is an additional 2 percent return.
This leads us to a super important conclusion - as the investment weights vary, the returns vary. In fact, each return has an associated risk profile, so it is prudent to state – as the weights vary, both the risk and return characteristics vary.
Now imagine this – for a given portfolio with ‘n’ number of stocks, wouldn’t it be awesome if you were to look at the past data and intelligently identify how much to invest in each stock so that the portfolio yields the best possible returns?
This is exactly what happens when you optimize your portfolio. Generally speaking, you can adjust the weights (or optimize your portfolio) such that, for the given set of stocks –
1) You identify the investment weights to achieve the best possible return or
2) You identify the investment weights to achieve the least possible risk
So the next time you meet your investment manager, do ensure you talk to him portfolio optimization and figure out if plans to optimize your portfolio. Ideally speaking, he should optimize the portfolio keeping your risk and return appetite in perspective.Disclaimer:
The author is VP, Educational Services, Zerodha. The views and investment tips expressed by investment experts on Moneycontrol are their own and not that of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.