This step requires a lot of research, analysis, and computation.
Few key parameters that one should consider at this stage are
Usually a portfolio manager uses a model like
Each of the above techniques require a book by themselves. But the crux is that you need to choose one of the methods to create a portfolio to allocate your funds to various investment opportunities that best suit your needs.
Mathematically multiple combinations of underlying securities are created as shown in table below.
Then the best combination of the securities that meets the goal and that does not increase the risk of the entire investment compared to a risk- free rate of return. Now a risk free rate of return is typically something like a treasury bill issued by the govt or for a retail investor the equivalent is a deposit in a bank.
| Quantity held by Fund 1 | Quantity held by Fund 2 | Quantity held by Fund 3 | Quantity held by Fund n | |
| Equity 1 | 100,000 | 50,000 | ||
| Equity 2 | 200,000 | 60,000 | ||
| Equity 3 | 300,000 | 70,000 | ||
| Equity 4 | 400,000 | 80,000 | ||
| Equity 5 | 500,000 | 90,000 |
Once the most optimal portfolio is determined the investments are made in the portfolio and thus a portfolio is constructed.
So, is that the end, can we roll the titles and credits on this investments exercise? No, not yet, we just started a large exercise.
There is a need to constantly monitor the portfolio, optimize it to keep the returns and risk in tandem, steer the portfolio to meet the given goal in terms of the total value to be returned to the investor.
Now that process of constantly monitoring and optimizing the portfolio is called portfolio optimization and rebalancing. We will discuss these in detail in the next episode.