Statement 1
An optimal portfolio is the most desired road, but there are several considerations that lie ahead. A key point of decision is to engage in conservative or aggressive investments. One could choose a mix of both to promote a balance. An additional thought is one of simple diversity in investments.
The conservative side of the investments would be those that have a small standard deviation. Thereby there is a low risk of a move below the mean, but also a low risk of one falling above. These investments produce slowly over time as the variances that occur will be small. On the diversification side the conservative investor will spread the investments out over different types of investments so that no single action would necessarily impact them all.
Living life in the fast lane is the aggressive side of the house. These investments have a higher deviation from the mean and therefore could win big. But they can lose big as well which is why the risk for these investments is much higher depending on the standard deviation. Diversity on the high-risk side is a simple matter. There is no diversity, or the diversity is very slim.
Aversion to risk leads investors to the low risk or riskless investments. An investor may choose to take some risky investments, but then counter the risk with a balance of riskless investments. This satisfies the need for some higher returns while maintaining the riskless gains in the even the risky investment takes a dive. Diversity can help stem those risks as well.
A diversified portfolio can counter actions that could cause investments to have diminished returns and capitalize on other actions that increase the value of investments. Being properly diversified assists in adding a buffer to the deviations by isolating investments from one another in terms of loss impact. A factor that impacts one investment may not impact another and therefore the balance is maintained.
Personally, I am rather conservative, but I have several high-risk investments that I shift around to test the waters. These risky investments do not severely impact my total portfolio as it is growing in diversity to ensure that impacts to one sector remain isolated.
Response 1
I agree with your point of view that minimization of risk or maximization of profits; clearly, these are the priorities of the investors in the long run. However, one can think that there may be investors who would like to have maximum profits with minimum risks. These are the ones who go for an optimal portfolio. An optimum portfolio can go along with a conservative or aggressive investor. A risk aversive investor may spread out its investments in smaller portions to dilute the effect of the higher deviation investments by, the lower deviations investments. You are right by saying that the lower variance or changes in the investment value shows the potential of a stable stream of value from the investment in the future. On the other hand, a higher tolerance for risk is more of a priority for aggressive investors who are looking for the maximum profits at the cost of potentially higher losses. However, why should maximum returns come at the cost of higher losses? It can also be diluted by using diversified and optimal portfolios.
Statement 2
It is a top priority for investors to hold an optimal portfolio. The idea of an optimal portfolio derives from the modern portfolio theory (Investopedia, 2017). This theory assumes that investors focus their efforts on minimizing risk in addition to gaining the highest possible return. Investors will usually act rationally within these parameters and will often times base their decision on the objective of maximizing return for a given acceptable level of risk (Investopedia, 2017). An efficient portfolio is most preferred by an investor because its risk and reward characteristics are the investors utility function. A portfolio that maximizes an investors preference with respect to return and risk is an efficient one.
An investor can make various choices, but they should determine how much risk they are willing to take on. Once this is determined investors are able to allocate or diversify their portfolios according to the results of that decision (Investopedia, 2017). Optimizing a portfolio in practical terms is somewhat difficult and cannot be completed easily. There are computer programs and serves used today to assist in determining optimal portfolios.
Conservative investing is an investing strategy that seeks to preserve an investment portfolios value by investing in lower risk securities (Investopedia, 2018). These may include fixed-income and money market securities and sometimes blue chip or large cap equities (Investopedia, 2018). Conservative investors have risk tolerances. These tolerances range from low to moderate. Investors who have a low risk tolerance are often less comfortable with the stock market and may prefer to avoid it completely. Conservative investing strategies may protect against inflation, but it will not earn a significant value over time (Investopedia, 2018).
Aggressive investment in portfolio management attempts to maximize returns by taking a relatively higher degree of risk (Elvis Picardo, CFA, 2018). Investment strategies that are aggressive are ideal for young adults, due to the lengthy investment horizon. This horizon enables them to ride out market fluctuations (Elvis Picardo, CFA, 2018). A high tolerance for risk is a definite prerequisite for an aggressive investment strategy, regardless of the investors age. Aggressive investors are more likely to take risks and conservative investors are less likely and more afraid to lose money. If investors, choose to be aggressive they would need increased active management than a conservative “buy and hold” strategy being that its more volatile and could require frequent adjustments depending on market conditions (Elvis Picardo, CFA, 2018).
Response 2
I agree with you that every investment consultant would give you the advice that you need to have an optimal portfolio. However, there indeed are several considerations underlying the optimality of a portfolio as per the need of the investor. A conservative investor will have a different approach towards optimal portfolio as compared to an aggressive investor. A conservative investor will have invested in investments with lower standard deviations. These lower standard deviations show the lower historical variance reported in the investment value. These types of investments do not produce large returns. The returns from these conservative investments grow steadily over time. Moreover, the conservative portfolio of investments is more spread out in small investments to even out the effect of the investments on the investor.
You have a good point here by evaluating that the aggressive investor, on the other hand is indeed going for higher returns which comes along with higher risk in the form higher standard deviations. These portfolios have higher variance in its history and thus are expected to be more unpredictable in the future as well. The diversification of aggressive portfolio can help the investor in diluting the effect of higher deviations.
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