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Risk Management and Portfolio Optimization

Portfolio / Risk Analysis Jul 27, 2008 - 10:43 AM GMT

By: Peter_Johansson

Portfolio Stock analysis based on technical analysis or fundamental analysis is getting a lot of attention and often form the the basis for investment decisions. Many private investors combine perhaps 5-10 assets into a portfolio and let their intuition guide the allocate between the assets. How this allocation could be done in an optimal way, analytically, receives little attention in financial newspapers and marketing from financial institutes although it has a great significance for expected returns and portfolio risk.


For every level of expected return, there is one optimal asset combination which offers the lowest possible risk, and for every level of risk, there is one optimal combination which offers the highest expected return. These portfolios are called "efficient portfolios" . When calculating efficient portfolios, three measures are needed:

  1. Expected returns for all portfolio assets (often estimated by averaging historical returns)
  2. Risk for all portfolio assets (estimated by volatility or standard deviation)
  3. Correlation between all portfolio assets

The correlation between two assets lies between -100% and 100%. The higher the correlation is between two assets, the more similar are the price movements of the assets. A high correlation, for example 70%, indicates that the assets tend to move in the same direction. If there is no relationship between the movements of two assets, then the correlation between them is zero. If correlation is negative the assets tend to move in opposite direction.

The risk of the portfolio will be less than the average of the risk of the individual assets. Portfolio risk also falls with correlation. The lower correlations are between assets of a portfolio, the lower the risk is of the portfolio . Diversification is thus be profitable when combining assets which are not entirely the same. But How Do We Combine Assets Into A Well-Balanced Portfolio?

A portfolio composed of many assets that are not highly correlated always offer a lower risk, but there is only one single optimal combination of assets which minimizes portfolio risk. There is no other combination of assets which can achieve a smaller portfolio risk. If your acceptable level of risk is higher you can optimize the portfolio so that risk is minimized while taking estimated returns in regard.

A lot of computer power is needed to identify efficient portfolios. With the Portfolio Optimization tool in Optimal Trader, you can easily calculate efficient portfolios for stocks and mutual funds. Portfolio Optimization is a risk management tools in Optimal Trader based on modern portfolio theory (for which Harry Markowitz received Nobel Prize in 1990).

Optimal Trader is a stock analysis software for analysis of stocks, funds, currencies, etc. In addition to risk management the software offers technical analysis based on neural networks and Portfolio Analysis.

By Peter Johansson

http://www.optimaltrader.net

Optimal Trader was founded in 2006 by Peter Pap de Pesteny Peter Pap de Pestény , M.Sc in Applied Physics and Electrical Engineering with specialization in Signal Processing. Peter Pap de Pestény has previously been working modeling different kinds of signals, among others with audio waves and movements of neural stem cells.

The ambition is to maximize the possibilities with technical analysis. Classic analysis software are often far too simple and do not work well in the overanalyzed stock market of today. Analysis methods have been improved with the power of modern digital signal processing and new models have been developed. This is the basis of Optimal Trader.

© 2008 Copyright Peter Johansson - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

Peter Johansson Archive

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