The Science of Portfolio Optimization
Once we have determined how much equity-related risk we are willing to
take, and have determined which securities look especially attractive, we put
the “pieces of the puzzle” together. We essentially solve for the security
weights that yield the highest diversification ratio subject to the risk-budget
constraint determined in the first section. Information about this metric is
given in the paper “Toward Maximum Diversification” in the Journal of Portfolio Management (Choueifaty and Coignard 2008).
Here is a link:
We can now add to the risk-budgeting dashboard by including the resultant
hypothetical portfolio characteristics in the table shown below:
There is a lot going on in the table above. In a nutshell, it shows
precisely how we adjust the portfolio characteristics based on our view of
markets. It bears mentioning that the “Rel Vol” column listed above means
“volatility relative to an equity benchmark”. Remember, when we become more
cautious of equities, we seek a lower portfolio beta. We solve for the highest
diversification ratio at this target beta, and the resulting relative
volatility is incidental to it.
Key Takeaway:
Drawdown is inextricably linked to the overall beta and diversification
properties of an investor’s portfolio. This part of the portfolio construction
process forms the science of our discipline.
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