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Portfolio Optimization

The document discusses portfolio optimization, which is the process of selecting an optimal portfolio distribution to maximize returns while minimizing costs and risks. It describes modern portfolio theory introduced by Harry Markowitz, which aims to maximize expected return for a given level of risk. The optimization problem is formulated as a constrained utility maximization problem. Mathematical tools used for large-scale portfolio optimization include linear programming, quadratic programming, and meta-heuristic methods. Example code in Python is also provided for portfolio optimization. Constraints mentioned include regulations, taxes, and transaction costs.

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34 views8 pages

Portfolio Optimization

The document discusses portfolio optimization, which is the process of selecting an optimal portfolio distribution to maximize returns while minimizing costs and risks. It describes modern portfolio theory introduced by Harry Markowitz, which aims to maximize expected return for a given level of risk. The optimization problem is formulated as a constrained utility maximization problem. Mathematical tools used for large-scale portfolio optimization include linear programming, quadratic programming, and meta-heuristic methods. Example code in Python is also provided for portfolio optimization. Constraints mentioned include regulations, taxes, and transaction costs.

Uploaded by

pramodkumar808751528270
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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PORTFOLIO

OPTIMIZATION
"Optimizing Investments for Maximum Returns"

ITNS SECTION 1
BATCH 2022-2026

SUBMITTED BY :
SAURAV 2022UIN3322

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr


INTRODUCTION
Portfolio optimization is the process of selecting an
optimal portfolio (asset distribution), out of a set of considered portfolios, according
to some objective. The objective typically maximizes factors such as expected return,
and minimizes costs like financial risk, resulting in a multi-objective
optimization problem. Factors being considered may range from tangible (such
as assets, liabilities, earnings or other fundamentals) to intangible (such as
selective divestment).
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Category 1 Categ oryS2eries 1 Series 2 SeriCeast3egory 3 Category 4
Modern portfolio theory
Modern portfolio theory was introduced in a 1952 doctoral thesis by Harry
Markowitz, where the Markowitz model was first defined.[1][2] The model
assumes that an investor aims to maximize a portfolio's expected return
contingent on a prescribed amount of risk. Portfolios that meet this
criterion, i.e., maximize the expected return given a prescribed amount of
risk, are known as efficient portfolios. By definition, any other portfolio
yielding a higher amount of expected return must also have excessive risk.
This results in a trade-off between the desired expected return and
allowable risk. This risk-expected return relationship of efficient portfolios
is graphically represented by a curve known as the efficient frontier. All
efficient portfolios, each represented by a point on the efficient frontier,
are well-diversified. While ignoring higher moments of the return can lead
to significant over-investment in risky securities, especially when volatility
is high,[3] the optimization of portfolios when return distributions are non-
Gaussian is mathematically challenging.
Optimization methods
The portfolio optimization problem is specified as a constrained utility-
maximization problem. Common formulations of
portfolio utility functions define it as the expected portfolio return (net
of transaction and financing costs) minus a cost of risk. The latter
component, the cost of risk, is defined as the portfolio risk multiplied by
a risk aversion parameter (or unit price of risk). For return distributions
that are Gaussian, this is equivalent to maximizing a certain quantile of
the return, where the corresponding probability is dictated by the risk
aversion parameter. Practitioners often add additional constraints to
improve diversification and further limit risk. Examples of such
constraints are asset, sector, and region portfolio weight limits
Mathematical tools
The complexity and scale of optimizing portfolios over many assets means that the work
is generally done by computer. Central to this optimization is the construction of
the covariance matrix for the rates of return on the assets in the portfolio.
Techniques include:
Linear programming
Quadratic programming
Nonlinear programming
Mixed integer programming
Meta-heuristic methods[10]
Stochastic programming for multistage portfolio optimization
Copula based methods
Principal component-based methods
Deterministic global optimization
Genetic algorithm
Example Code - Python for Portfolio
Optimization
Optimization constraints
• Regulation and taxes

• Investors may be forbidden by law to hold some assets. In some cases, unconstrained
portfolio optimization would lead to short-selling of some assets. However short-selling can
be forbidden. Sometimes it is impractical to hold an asset because the associated tax cost is
too high. In such cases appropriate constraints must be imposed on the optimization process.

• Transaction costs

• Transaction costs are the costs of trading in order to change the portfolio weights. Since the
optimal portfolio changes with time, there is an incentive to re-optimize frequently. However,
too frequent trading would incur too-frequent transactions costs; so the optimal strategy is to
find the frequency of re-optimization and trading that appropriately trades off the avoidance
of transaction costs with the avoidance of sticking with an out-of-date set of portfolio
proportions. This is related to the topic of tracking error, by which stock proportions deviate
over time from some benchmark in the absence of re-balancing
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