This is also termed as the ‘top-down’ approach. It is more structured and preferred by institutional investors, This approach identifies three distinct stages in the selection of an optimal portfolio. The process of portfolio construction begins with the capital avocation decision. That is, apportionment of the total indigestible funds between a risk-free asset of the optimal portfolio of second stage, called the asset allocation decision, involves the construction of the optimal risky portfolio, referred to at the capital allocation decision stage. This is consist of the distribution of the risky investment across broad asset classics shares (stocks), the instruments (bonds), real assets and so on. The final stage is the security selection decision, that is, choice of securities within each asset class.
It is called the two-step or top-down optimization approach as the focus of the top managerial is on independent organisation of risky portfolios, namely, the asset-class portfolios and portfolios within each asset-class, Hence, the investment manager cannot benefit from low co-variance between asset classes, This deficiency is overcome by contrapuntal on co-variance between various classes of assets. The weights of a risky portfolio risk-free or various asset portfolios, are frequently adjusted to take advantage of marketing conditions an activity termed as the market timing.
The one-step optimization is elaborated below,