Portfolio optimization (also referred to as portfolio rebalancing) involves strategically adjusting portfolio asset weights in order to optimize asset allocation for an investor’s desired balance between growth and risk. Every investor has unique objectives, timelines, and resources, and a well-crafted portfolio will contain asset weights appropriate for an investor’s goals. 

Markets, however, are dynamic, and assets change in value over time. As the stock market rises, for instance, a portfolio with an asset weight of 50% stocks and 50% bonds will become more heavily weighted towards stocks as the value of the stocks increase relative to the bonds. The difference between target weight and actual weight is referred to as “portfolio drift.” 

Unmanaged portfolio drift exposes investors to unintended levels of risk, much of which may ultimately be in the form of uncompensated risk because drift occurs as a result of asset appreciation/depreciation and not as a result of intentional allocation. 

The goal of portfolio optimization is to make sure that portfolios consistently reflect the intended goals of the investor by minimizing risk relative to target asset weights.

According to the Financial Industry Regulatory Authority, three common strategies for portfolio optimization involve: 

  1. Moving money to the underperforming asset classes until they return to the target allocation;
  2. Directing an increased percentage of new contributions to the underperforming asset classes;
  3. Selling off a portion of the outperforming asset classes and reinvest the profits in the underperforming asset classes. 

The frequency with which portfolio optimization should occur differs from investor to investor, and depends on, among other things, portfolio drift and market volatility. There are trading costs and opportunity costs associated with portfolio optimization, though these may pale in comparison to the long-term costs of allowing a portfolio to drift along with the market.

 

Why Optimize?: An Example from Past Markets 

As a practical example of why portfolio optimization is so critical in maintaining an investor’s target asset weights, consider the following…

In April 2010, an investor opened a $500,000 portfolio and decided to allocate 50% to stocks and 50% to bonds. For the stock portion of the portfolio, the investor chose to go with the SPDR S&P 500 ETF Trust (SPY), which traded at about $120 per share in April 2010. For the bond portion, the investor chose Vanguard Total Bond Market Index Fund Investor Shares (VBMFX), which traded at about $10.50 per share in April 2010. 

Assuming the investor (or the investor’s asset manager) did not optimize the portfolio at any point during the following 10 years, the asset weights would have experienced considerable drift. The portfolio’s stock weight would have increased from 50% in April 2010 to 67% in April 2020. SPY shares traded at about $270 in April 2020, and the value of the portfolio’s stock position would have increased from $250,000 to $562,500. Meanwhile, the portfolio’s bond weight would have decreased relative to stocks, dropping from 50% in 2010 to 33% in 2020. VBMFX shares traded at about $11.40 in April 2020, and the value of the portfolio’s bond position would have increased only slightly from $250,000 to $271,500. 

Assuming the investor’s objectives have not changed since the portfolio’s inception, this new portfolio is highly problematic. 

First and foremost, the investor created the portfolio with the intention that their investments would be split 50/50 between stocks and bonds. A 50/50 portfolio was their ideal blend of risk and growth, while a 67/33 portfolio is likely far too risky. 

Second, by not optimizing the portfolio, the investor was exposed to considerable market volatility. The investor assumed a great deal of risk, none of which was compensated for in the portfolio’s other asset classes.

Portfolio optimization is crucial to long-term investment success because asset weights and risk levels shift with the market. Steady, purposeful management can better prepare investors for times of intense market volatility.

 

How Magnifi Helps Advisors Optimize Client Portfolios

Having the right information at the right time is crucial to optimizing portfolios, especially during times of prolonged market volatility. The online ecosystem of investment products is scattered and complex, and it can be overwhelming to research and compare products, even in the best of times. 

This is where Magnifi can help. 

Magnifi makes it easy to discover, analyze, and compare different investment products. The platform uses an industry-leading search function that uses semantics to infer meaning from natural language – similar to how Google works. For instance, if you are interested in searching for high performance bond funds with low fees, simply type the phrase “high performance bonds low fees,” and Magnifi quickly presents a list of funds that match those criteria. Search results feature detailed information for each product, including fees, returns, and volatility, and the compare feature makes it easy to identify the best product for your search preferences. With Magnifi’s premium services, you can upload an existing portfolio and the platform’s powerful search and compare tools analyze it and suggest changes to improve asset allocation. Magnifi shortens the time it takes to research and find the right product by making ease of use the center of the platform’s functionality.

Market volatility is on every investor’s mind these days, and as investors increasingly scrutinize their portfolios for weakness, asset managers would do well to arm themselves with tools that help them make the right decisions quickly.

Magnifi is changing the way we shop for investments, with the world’s first semantic search engine for finance that helps users discover, compare and buy investment products such as ETFs, mutual funds and stocks. Try it for yourself today.

This blog is sponsored by Magnifi. The information and data are as of the publish date unless otherwise noted and subject to change. This material is provided for informational purposes only and should not be construed as individualized investment advice or an offer or solicitation to buy or sell securities tailored to your needs. This information covers investment and market activity, industry or sector trends, or other broad-based economic or market conditions and should not be construed as investment research or advice. Investors are urged to consult with their financial advisors before buying or selling any securities. Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. Past performance is no guarantee of future results. This content may not be reproduced or distributed to any person in whole or in part without the prior written consent of Magnifi. [As a technology company, Magnifi provides access to tools and will be compensated for providing such access. Magnifi does not provide broker-dealer, custodian, investment advice or related investment services.]