Investing? How to build an optimal portfolio

Lucky scratched his head. Looked around. Buried his head again in the newspaper. 

Looked up again. Scratched his beard. Got up and hesitantly walked up to the lady sitting on the far end right corner of the student lounge at the University.

She looked up at the smartest guy in her executive education class. Lucky was a successful software developer, who had made money through stock options that his company gave him for performance. Gesturing him to take the chair opposite her, she asked, "where are you lost?".

"Look at this Professor Nicky", said Lucky, holding out the newspaper to her and pointing at the article that he was reading.

"Modern Portfolio Theory: Bigger Profit with less risk", read the heading. Nicky quickly scanned the article and asked, "So?"

Lucky: I have some money as fixed deposit with my bank. It is giving me a return of 9.25 percent per annum. I know it is a very safe way to get returns. But I also know that I am not maximizing my returns.

I may get more returns by taking some measured risk. I am a bachelor. I don't need to send money home. I can afford to take some risk.

But I don't know how to go about doing it. I am comfortable with programming, but finance scares me. If you can help me understand this article and what is modern portfolio theory, I might get over my fear and get started.

Nicky: But you can go to an investment advisor!

Lucky:  Yes. But I don't want to. I have had a bad experience earlier when one of them sold me a Unit Linked Investment Plan and I lost half of my invested money. I later came to know that they get a hefty commission for selling some of the products. So now I want to manage my investments on my own.

Nicky: Well, once bitten twice shy. But not all investment advisors are bad. And now, even the regulators are tightening the norms and making it safer for the investors. Having said that, it is good that you want to manage your own portfolio.

Let me start from the beginning. Harry Markowitz, a Nobel laureate in economics, introduced modern portfolio theory, a theory of finance that shows how risk averse investors can construct portfolio to maximize expected return for a given level of risk or to minimize risk for a given level of expected return.

He developed a simple framework, known as Mean-variance analysis, to analyze the tradeoff between risk and return. To diversify the money in risky and risk free assets, the first step is to find the optimal portfolio of risky assets and the second step is to find the best combination of risk free asset and optimal risky portfolio.

Lucky: Now you are losing me. Risk free? Optimal risky portfolio?

Nupur: Risk free assets are typically government issued short term bills or bonds. Even though technically a fixed deposit is not risk free, you may consider it to be close to risk free and continue to invest part of your money in fixed deposits.

An optimal risky portfolio is the market portfolio that provides maximum reward to risk ratio; in other terms, the best combination of risky assets to be mixed with safe assets to form the complete optimal portfolio.  It can be constructed by using a simple tool, Solver, in excel.

Lucky: This article here says that there can be many minimum variance portfolios. If that is the case, then which one should I choose?

Nicky: On right track! To build an optimal risky portfolio, you need to maximize the ratio of portfolio excess return to portfolio risk (standard deviation). This ratio is known as the Sharpe Ratio. Once you find the portfolio which maximizes the sharpe ratio, you can take that portfolio and invest part of your money in it and the balance in a risk free asset.

Lucky: How will I know how much to invest in each?

Nicky: Ah that really depends upon how much risk you want to take. If you don't want to take any risk, then your investment in risky portfolio will be zero percent. But if you want to take some degree of risk, then you will invest say 30 or 40 percent of your money in the risky portfolio and balance in risk free assets. It really depends upon your risk appetite.

Lucky: Wow! And all this was told by Markowitz?

Nicky: Yes. And he said many more things. But I guess this is enough for today. If you want to know more about his and his theory, google his name and you will find his originally published paper in the Journal of Finance in 1952.