Today, thanks to technological progress in general and to the Internet in particular, the tools for building efficient portfolios are becoming accessible to individuals. Most portfolio optimization software packages are still aimed at institutional investors and cost thousands of dollars to buy or, in some cases, rent. But one Website, www.FinPortfolio.com, has brought Markowitz ’s insight to the masses. Launched in February 2000 by two former members of Goldman Sachs ’s risk management team, the site offers investors a portfolio- optimization feature along with other advanced analytical tools. The basic service is currently free, though the company plans eventually to charge some users an annual or quarterly fee. 

FinPortfolio’s optimization feature is less sophisticated than the more expensive products in terms of customization possibilities and running “what if ”scenarios. But by supplementing it with resources available at other sites, you can piece together a powerful analytical package at little or no cost. You might, for example, register for services at www.FinPortfolio.com, www.riskgrades.com, and www.valuengine.com. To illustrate how such a combination might function, we used these sites to optimize the collection of securities shown in the table below. 

Sixty percent of this portfolio ’s total assets are anchored in an S&P 500 index fund. The remainder is divided more or less equally among seven stocks, each a leader in an industry that might be represented in a well-rounded portfolio: technology, health care, financial services, energy, telecommunications, retail, and media/entertainment. The allocation looks reasonable. But looks can be deceiving, as a run through FinPortfolio ’s optimization feature after the close of trading on November 7 demonstrated. 

The software first asked what constraints, if any, we wished to place on the security weights. To insure that the index remained the core of our portfolio, we specified that it account for 25 to 75 percent of assets. We also decided that no individual stock should amount to more than 20 percent of the whole, to avoid concentrated positions and there- fore unnecessary risk. 

The program then calculated the expected three-year returns and share price volatility for each of the seven stocks and the index fund, together with the correlations among them —that is, how closely their price movements might mirror one another —based on the past three years of market history. Next, given these predictions, it found all possible combinations of the securities on the efficient frontier. In other words, for each point on a spectrum of risk, the program determined the portfolio mix offering the highest return. 

Which of the “optimal ”combinations of securities would be the right one for you? That would depend on your investment goals and risk tolerance. Say you are comfortable with the pre-optimization volatility of the original allocation: 20.4 percent. One of the most surprising results of the optimization analysis was that the portfolio ’s return —18 per- cent —can be improved on while maintaining this same level of risk. Specifically, the software found that by cutting the index fund allocation to 25 percent, eliminating Merrill Lynch and WorldCom, and more than doubling Johnson &Johnson ’s weighting, along with some other minor tweaking, you could raise the expected return to 22.4 percent without increasing volatility (see graph above). That may be as close as you ’ll come to a free lunch. 

But what if you’re intent on maintaining exposure to the financial ser vices industry? One option is to take FinPortfolio’s advice and dump Merrill, then search for a replacement drawn from the same sector that offers less risk for a similar return. To find a set of potential alternatives, you might visit www.valuengine.com. By typing in Merrill’s ticker (MER) on the opening page and then clicking on the “More Detailed Analysis” option on the subsequent screen, you generate a list of five stocks with prices that move similarly to Merrill ’s:Bear Stearns, Chase Manhattan, Citigroup, J. P. Morgan, and Morgan Stanley Dean Witter. 

The next step would be to choose the best substitute for Merrill. To determine which stock on the list is least risky, you might surf over to www.riskgrades.com. This site —run by RiskMetrics, formerly a division of J. P. Morgan — uses a proprietary sys- tem to assign a score to any security you select, based on its historical price volatility and how that compares with the volatility of a basket of global equities. The safest score is 0 (associated with cash); the most speculative, 1,000.You can get the grades of the five proposed alternatives by entering their tickers, one by one. The winner: Citigroup, with a score of 194, compared with grades ranging from 237 to 333 for the other four stocks. 

Now you’d substitute Citigroup for Merrill in the original portfolio an run it through FinPortfolio’s program. Before optimization, the new security mix, with Citigroup in place of Merrill, had a volatility of 19.7 percent and an expected return of 18.9 percent. That was a clear improvement on the 20.4 percent volatility and 18 percent return of the non-optimized original portfolio. Applying the program revealed that it could be even better: Deleting WorldCom, cutting the index allocation, and adding to other positions boosted the Citigroup portfolio’s expected return to 21.7 percent, while holding its risk constant. The optimization of the original portfolio, shown in the table at the top of page 24,also kept volatility constant — at 20.4 percent — and boosted returns, to 22.4 percent. But both figures were higher than those for the Citigroup optimization. As Markowitz ’s 1952 paper suggested, and FinPortfolio now documents, higher rewards do come with higher risks. In other words, there is no free lunch after all.