Investment strategy: “Garbage in, garbage out” portfolio optimization

In the previous Flashes, we laid the foundations for building our desired portfolio through individual risk profiling (Flash 14 and 15), a discussion of the asset classes and benchmarks to be considered (Flash 18) and the allocation of risk and return forecasts (Flash 17).

The omnipresent and popular approach to portfolio construction in the industry is portfolio optimization. This concept goes back to a contribution by Harry M. Markowitz in 1952, who claimed that inefficient portfolios could be transformed into efficient portfolios by adjusting the portfolio composition using a non-linear quadratic equation. A portfolio is considered efficient when the optimizer can no longer find a portfolio composition that delivers a higher expected return for the same expected risk.

The optimization equation must be fed with numerous assumptions, namely:

• Which asset classes are available to the optimizer? In Flash 18 we explained that the freedom in choosing asset classes is enormous.
• What return and risk expectations are assigned to the selected asset classes? In our tour d’horizon in Flash 17 we showed the large scope for design among the available estimation methods.
• Finally, weights of the individual asset classes can be subject to minimum or maximum restrictions. These limits, which largely predetermine the optimization outcome, often appear rather arbitrary.

The “optimal portfolio” produced by the optimizer is of course only as good as the numerous inputs with which it is fed: “Garbage in, garbage out.” The chart of the week illustrates how even a change in the method used to estimate expected returns can significantly alter the composition of the optimal portfolio.

Why does this optimization equation, now over 70 years old, persist so stubbornly despite these obvious weaknesses and appear to underpin almost every investment proposal produced by the industry? The advisor can conveniently refer to the optimizer – the god from the machine (deus ex machina) – thereby avoiding the need to professionally justify the portfolio proposal. Attractive and simple, but questionable whether this truly serves the client’s interest.

Economico does not rely on portfolio optimization when constructing its standard portfolios. Instead, the key allocation questions in portfolio construction are addressed with sound economic expertise and common sense. We will discuss this more concretely in the upcoming Flashes.