Risk-based Portfolio Optimization is ... Risky!
It’s not enough to say you’ve mitigated all your risk in the face of present economic change, but one must be able to quantify, measure and modify it often, in order to stay on the maximum potential return of a chosen portfolio strategy over time periods. Note the emphasis on the plural.
The dilemma, to maintain a selection of quality assets on a portfolio's efficient frontier that add incrementally more return while not adding more risk. The problem is that flushing out risk can bring you closer to the market average.
Risk-based portfolio optimization schemes, such as Mean-Variance Optimization (MVO) can suffer from unintentional mistakes (decisions made) because MVO tends to weight the historically higher returning assets more heavily, at the expense of ignoring potentially higher returning assets looking forward.
In other words, there may be a greater chance that a great performer may no longer perform great, and alternative assets could add a higher return while decreasing the overall chance of loss of capital of the portfolio.
Also, when certain assets have appreciated or depreciated significantly throwing your targetted asset allocation off balance, one must be able to objectively consider alternative investments that will appreciate, and know which existing assets to release (because they may be heading downward).
Beta is a measure of systematic (market) risk or volatility; it relates how a stock varies as compared to the market index or average. Beta of 1 is nominal, your asset moves as much as the market. Beta of less than 1 means movement is tempered and greater than 1 means it is accentuated. Beta has meaning only in that you as an investor have a perticular risk aversion. Few people can tolerate assets with beta much greater than 2.
MVO uses Beta in its analysis. Because Beta is a measure of PAST performance MVO reduces alpha. Alpha relates a fund's risk-adjusted returns to the market average. Alpha is incremental gain versus the market average. Alpha of 1 means 1% better.
With mutual funds, we want as much Alpha as possible so that (a) we can outperform the market and (b) we feel justified in paying fund managers their fees, expenses and loads.
We'll introduce an improved method of portfolio optimization in another post.
The dilemma, to maintain a selection of quality assets on a portfolio's efficient frontier that add incrementally more return while not adding more risk. The problem is that flushing out risk can bring you closer to the market average.
Risk-based portfolio optimization schemes, such as Mean-Variance Optimization (MVO) can suffer from unintentional mistakes (decisions made) because MVO tends to weight the historically higher returning assets more heavily, at the expense of ignoring potentially higher returning assets looking forward.
In other words, there may be a greater chance that a great performer may no longer perform great, and alternative assets could add a higher return while decreasing the overall chance of loss of capital of the portfolio.
Also, when certain assets have appreciated or depreciated significantly throwing your targetted asset allocation off balance, one must be able to objectively consider alternative investments that will appreciate, and know which existing assets to release (because they may be heading downward).
Beta is a measure of systematic (market) risk or volatility; it relates how a stock varies as compared to the market index or average. Beta of 1 is nominal, your asset moves as much as the market. Beta of less than 1 means movement is tempered and greater than 1 means it is accentuated. Beta has meaning only in that you as an investor have a perticular risk aversion. Few people can tolerate assets with beta much greater than 2.
MVO uses Beta in its analysis. Because Beta is a measure of PAST performance MVO reduces alpha. Alpha relates a fund's risk-adjusted returns to the market average. Alpha is incremental gain versus the market average. Alpha of 1 means 1% better.
With mutual funds, we want as much Alpha as possible so that (a) we can outperform the market and (b) we feel justified in paying fund managers their fees, expenses and loads.
We'll introduce an improved method of portfolio optimization in another post.
Comments