How could ‘Optimization of Portfolio’ be achieved?

An investor's portfolio should ideally have several asset
classes and different assets within each asset class. When an asset is added to the portfolio it
is expected to provide a certain return and there is also a certain amount of risk that is
associated with the expected return.

With time, the risk-return
profile of different assets changes. The expected return of some assets may go up with an
increase or decrease in the risk; for others the expected return may have come down with a change
in the associated risk.

This requires the assets in the portfolio to
be altered accordingly to increase returns while keeping the associated risk at an acceptable
level.

Portfolio optimization involves eliminating certain assets
and substituting them with better alternatives that may have become available. An investor or
portfolio manager has to constantly be on the lookout for such
opportunities.

For example if a company has undergone a turnaround
and turned profitable, it would make sense to acquire shares of that company while selling shares
of a company that is not doing that well. Similarly if the portfolio has bonds and interest rates
are expected to rise, the bonds could be sold.

Portfolio
optimization involves a lot of mathematical modeling and calculations to determine the best
choices among the available options. While altering a portfolio there are also several
transaction costs involved which have to be kept in mind. As the transaction costs makes frequent
changes unprofitable, all changes have to be made carefully and with a lot of
thought.