Question

In: Finance

Practical portfolio optimization can be summarized as "finding optimal portfolio weights for available investment assets that...

Practical portfolio optimization can be summarized as "finding optimal portfolio weights for available investment assets that would minimize risk while maximizing returns given investor’s risk aversion”. However, pure portfolio optimization suffers from a flaw–it gives a lot of weight to the assets (stocks, ETFs, bonds, etc) that performed well recently.

  1. Explain why this is a flaw.
  2. Identify some practical solutions that could mitigate this flaw.

Solutions

Expert Solution

Giving lot of weightage to the assets which have performed well recently is a flaw because past performances don't guarantee future returns. In fact, practical data may show that the assets that have performed well recently, are more susceptible to poor performance in future as many assets are cyclical in nature in terms of performance of their returns. The returns on stock and gold, for example, are mostly inversely correlated. So if in the recent past, stocks have performed well (and gold poorly) then the portfolio will be more skewed towards stocks. This will make the portfolio risky as if there is a down cycle of stocks then the portfolio will not be able to take advantage of better returns from gold.

To mitigate this flaw, it is important to identify an optimum asset allocation and rebalance the portfolio periodically so that it is not skewed in favor of assets which have performed well recently. To achieve better diversification, assets selected should be least correlated with each other.


Related Solutions

A portfolio manager who uses mean-variance optimization to construct an optimal portfolio will satisfy which of...
A portfolio manager who uses mean-variance optimization to construct an optimal portfolio will satisfy which of the following? Group of answer choices Only investors with low risk tolerance. Only investors with high risk tolerance. Only investors with moderate risk tolerance. All investors, regardless of their level of risk.
How do you find the optimal weights of a portfolio in excel using solver given a...
How do you find the optimal weights of a portfolio in excel using solver given a predefined risk (target standard deviation)?
Portfolio Risk Assume A portfolio consists of two assets, Investment A and Investment B. Market Value...
Portfolio Risk Assume A portfolio consists of two assets, Investment A and Investment B. Market Value of Investment A at beginning of period: $600 Market Value of Investment B at beginning of period: $300 Investment A has an expected return of 8% Investment B has an expected return of 3% Investment A has a standard deviation (volatility) of returns 15% Investment B has a standard deviation (volatility) of returns of 6% The correlation of returns for Investment A and Investment...
CURRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the...
CURRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of an asset expansion presently being undertaken. Fixed assets total $3 million, and the firm plans to maintain a 55% debt-to-assets ratio. Rentz's interest rate is currently 8% on both short-term and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level...
CURRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the...
CURRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $3 million as a result of an asset expansion presently being undertaken. Fixed assets total $2 million, and the firm plans to maintain a 60% debt-to-assets ratio. Rentz's interest rate is currently 8% on both short-term and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level...
CURRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the...
CURRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $3 million as a result of an asset expansion presently being undertaken. Fixed assets total $2 million, and the firm plans to maintain a 60% debt-to-assets ratio. Rentz's interest rate is currently 8% on both short-term and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level...
CURRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the...
CURRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $3 million as a result of an asset expansion presently being undertaken. Fixed assets total $2 million, and the firm plans to maintain a 50% debt-to-assets ratio. Rentz's interest rate is currently 8% on both short-term and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level...
CURRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the...
CURRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $4 million as a result of an asset expansion presently being undertaken. Fixed assets total $3 million, and the firm plans to maintain a 60% debt-to-assets ratio. Rentz's interest rate is currently 10% on both short-term and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level...
URRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the...
URRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $4 million as a result of an asset expansion presently being undertaken. Fixed assets total $1 million, and the firm plans to maintain a 60% debt-to-assets ratio. Rentz's interest rate is currently 9% on both short-term and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level...
CURRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the...
CURRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $3 million as a result of an asset expansion presently being undertaken. Fixed assets total $1 million, and the firm plans to maintain a 45% debt-to-assets ratio. Rentz's interest rate is currently 8% on both short-term and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT