Portfolio optimization is a procedure for measuring and controlling portfolio risk and expected return. At its simplest, portfolio optimization is basically diversification—reducing portfolio risk by combining assets whose specific risks offset each other. But optimization usually also takes into consideration the correlations between assets—the extent to which their prices tend to move together. By combining stocks in different groups whose price moves tend to complement one another, an optimizer can build a portfolio that offers the highest level of return for each level of risk.
Of course, the “optimal” portfolio for a given client will depend upon the client’s perception of risk. Risk should thus be measured relative to the index the client uses as a performance benchmark. This may be the S&P 500, the Value Line Index or a “normal portfolio” constructed to typify a particular investment style. The degree to which the actual portfolio differs from the benchmark determines the portfolio’s risk. The riskier the portfolio, the higher the return it should achieve over the long term.