Portfolio Optimization Models

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What is Portfolio Optimization?

Portfolio Optimization also known as ‘Optimal Asset Allocation’ is a part of the ‘Modern Portfolio Theory (MPT)’ by Harry Markowitz. It aims at creating a balanced portfolio that will yield the maximum possible return while maintaining the amount of risk that the investor is willing to carry. Portfolio Optimization should result in an ‘Efficient Portfolio’ that will be generating the highest possible return at the set risk tolerance.

What is Modern Portfolio Theory (MPT)?

Modern Portfolio Theory was pioneered by Harry Markowitz in a paper published by the Journal of Finance in 1952. MPT assumes that risk-averse investors can construct a balanced portfolio of multiple assets to maximize expected return based on a given level of market risk. It makes use of statistical measures such as variance and correlation to prove how an individual investment’s return is less important than its behaviour in the context of the entire portfolio.

What is a (Markowitz) Efficient Portfolio and an Efficient Portfolio Frontier?

Efficient Portfolio is a set of diversified assets that is optimized in a way that will provide the investor with the highest expected return at a given and tolerated level of risk.
Efficient Portfolio Frontier (‘Efficient Frontier’) is a modern portfolio theory tool that indicates the set of portfolios with the best possible expected return given the accepted level of risk. The Markowitz Efficient Frontier can be plotted on a graph, with the portfolio’s risk on the X-axis and the expected return on the Y-axis. It is possible to draw an upward sloping hyperbola to connect all of the efficient portfolios.

What is the Markowitz Mean-Variance Analysis (Mean-Variance Optimization)?

Mean-Variance Analysis is a process of weighting risk against expected return. It has two main parts: variance and expected return. Mean-Variance Analysis stands for a part of the Markowitz Modern Portfolio Theory and, as such, assumes that investors will make rational decisions about investments if they have complete information. The Mean-Variance Analysis is also at the core of the Markowitz Portfolio Optimization which means that it allows for finding the biggest reward at a given level of risk or the least risk at a given level of return (called Mean-Variance Optimization). See a Markowitz Mean-Variance Optimization Example

What are Portfolio Optimization Methods / Techinques?

1/ Mean-Variance Optimization
2/ Treynor-Black Model
3/ Black-Litterman Model
4/ Naive Optimization

To read more about Portfolio Optimization Methods and see examples go here.

What Are The Factors Affecting Portfolio Optimization?

There are several factors that can affect portfolio optimization such as the following:

1/ Behavioral factors: behavioral factors include the investor’s risk outlook and risk aversion as well as the choices they make on the investment horizon and instruments.
2/ Correlation: correlation plays an important role in the choice of the portfolio construction method as it guides diversification.
3/ Market regime: market regimes are a good factor to look at while evaluating the portfolio construction methods since they influence the optimum of the minimum variance.

Why is the Efficient Portfolio Management important?

The Efficient Portfolio Management and Portfolio Management alike have the objective of overseeing a group of investment and meet the long term financial objectives and risk tolerance of the investor. The key elements of the efficient portfolio management are as follows:

  • Asset allocation,
  • Diversification,
  • Re-balancing.

According to the Modern Portfolio Theory, the Markowitz Portfolio Optimization allows for making right decisions about the above factors to reach an efficient portfolio that will bring the highest possible expected return at the tolerated level of risk and, as a result, will meet the long term financial objectives of the investor.

Read more on the Portfolio Management here.

Read more on the topic of Portfolio Optimization

Efficient Frontier Portfolio Optimisation in Python
Portfolio Optimization in Modern Portfolio Theory. Portfolio Optimization Example
Portfolio Optimization Theory

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