How to stretch the blanket? Using optimization tools – Part I
When making decisions, executives often face the “short blanket dilemma”: resources are scarce and those allocated to certain tasks, assets or products with uncertain results cannot be allocated to others. How to balance the portfolio?
There are always more projects to implement or good ideas to execute than there are resources to carry them out. Or by not neglecting any project, valuable resources are consumed, neglecting the long term and putting the focus of the operation at risk. Given this situation, what would be the optimal mix to allocate these resources to all the activities that the company would like to accomplish, without losing focus on the business?
The executive must decide how to assign time, budget and people to different projects, programs, products, channels, regions, subsidiaries or business units, in order to keep the operation balanced and obtain the best possible results at a lower cost. This is precisely the challenge of balancing the portfolio.
Through the application of new portfolio optimization methodologies that include a correct risk weighting for each asset, project, channel or product, it will be possible to select the optimal combination of these based on the value they contribute to the business as a whole.
Finding the efficient frontier (and not settling for it)
Optimizing a company’s resource allocation means finding the portfolio of projects or assets that maximizes the value represented by at least two opposing objectives. These dilemmas often present themselves in pairs of conflicting objectives: short term vs. long term, capital investment vs. cash generation, or willingness to profit vs. hedging at a given level of risk (or cost).
To achieve maximum value from a portfolio, you must first find all the different portfolios that, by combining and prioritizing different projects or assets, generate different results. Portfolios that maximize returns for the same level of risk are called “portfolio efficient frontier”.
The second step for the optimization of a portfolio will be to try to take it towards an efficient frontier. For this, the assets that compose it must be optimally assigned and weighted. Once the portfolio is located on this border, an attempt will be made to achieve the best location of the portfolio within the border.
Although the choice of the desired level of risk will be a matter of another decision of the company’s identity, the fact of understanding the exchange (trade-off) between risk and results will allow us to explore the key variables and move, within the limits of efficiency, towards the point that best suits the business strategy and the culture of the company.
Finally, the challenge will be to try to jump to a higher efficient frontier. For this, we will have to look for new external opportunities through a probabilistic risk assessment. This will allow us to enhance the analysis, to capture greater value for the business.
Portfolio optimization tools allow us to follow these steps to create portfolios that maximize value for the business.
Partner at Tandem.