Portfolio Optimization

Stephen Boyd

EE103
Stanford University

December 8, 2017
 Outline

Return and risk

Portfolio investment

Portfolio optimization

Return and risk 2

 Return of an asset over one period

I asset can be stock, bond, real estate, commodity, . . .

I invest in a single asset over period (quarter, week, day, . . . )
I buy q shares at price p (at beginning of investment period)
I h = pq is dollar value of holdings
I sell q shares at new price p+ (at end of period)
p+ −p
I profit is qp+ − qp = q(p+ − p) = p h
p+ −p profit
I define return r = p = investment
I profit = rh
I example: invest h = $1000 over period, r = +0.03: profit = $30

Return and risk 3

 Short positions

I basic idea: holdings h and share quantities q are negative

I called shorting or taking a short position on the asset
(h or q positive is called a long position)
I how it works:
– you borrow q shares at the beginning of the period and sell them at
price p
– at the end of the period, you have to buy q shares at price p+ to
return them to the lender
I all formulas still hold, e.g., profit = rh
I example: invest h = −$1000, r = −0.05: profit = +$50
I no limit to how much you can lose when you short assets
I normal people (and mutual funds) don’t do this; hedge funds do

Return and risk 4

 Examples

prices of BP (BP) and Coca-Cola (KO) for last 10 years

70
KO
BP

60

50

40
Prices

30

20

10

0
0 500 1000 1500 2000 2500
Days

Return and risk 5

 Examples

zoomed in to 10 weeks
70
KO
BP

60

50

40
Prices

30

20

10

0
1600 1605 1610 1615 1620 1625 1630 1635 1640 1645 1650
Days

Return and risk 6

 Examples

returns over the same period

0.2
KO
BP
0.15

0.1

0.05
Returns

−0.05

−0.1

−0.15

−0.2
1600 1605 1610 1615 1620 1625 1630 1635 1640 1645 1650
Days

Return and risk 7

 Return and risk

I suppose r is time series (vector) of returns

I average return or just return is avg(r)
I risk is std(r)
I these are the per-period return and risk

Return and risk 8

 Annualized return and risk

I mean return and risk are often expressed in annualized form

(i.e., per year)
I if there are P trading periods per year
– annualized return √
= P avg(r)
– annualized risk = P std(r)
(the squareroot in risk annualization comes from the assumption
that the fluctuations in return around the mean are independent)
I if returns are daily, with 250 trading days in a year
– annualized return √
= 250 avg(r)
– annualized risk = 250 std(r)

Return and risk 9

 Risk-return plot

I annualized risk versus annualized return of various assets

I up (high return) and left (low risk) is good
25

SBUX
20

GS
Annualized Return

15

BRCM
MMM
10

USDOLLAR
0
0 10 20 30 40 50 60
Annualized Risk

Return and risk 10

 Outline

Return and risk

Portfolio investment

Portfolio optimization

Portfolio investment 11
 Portfolio of assets

I n assets

I n-vector ht is dollar value holdings of the assets

I total portfolio value: Vt = 1T ht (we assume positive)

I wt = (1/1T ht )ht gives portfolio weights or allocation

(fraction of total portfolio value)

I 1T wt = 1

Portfolio investment 12
 Examples

I (h3 )5 = −1000 means you short asset 5 in investment period 3 by

$1,000
I (w2 )4 = 0.20 means 20% of total portfolio value in period 2 is
invested in asset 4
I wt = (1/n, . . . , 1/n), t = 1, . . . , T means total portfolio value is
equally allocated across assets in all investment periods

Portfolio investment 13
 Portfolio return and risk

I asset returns in period t given by n-vector r̃t

I dollar profit (increase in value) over period t is r̃tT ht = Vt r̃tT wt
I portfolio return (fractional increase) over period t is

Vt+1 − Vt Vt (1 + r̃tT wt ) − Vt
= = r̃tT wt
Vt Vt
I rt = r̃tT wt is called portfolio return in period t
I r is T -vector of portfolio returns
I avg(r) is portfolio return (over periods t = 1, . . . , T )
I std(r) is portfolio risk (over periods t = 1, . . . , T )

Portfolio investment 14
 Compounding and re-investment

I VT +1 = V1 (1 + r1 )(1 + r2 ) · · · (1 + rT )
I product here is called compounding
I for |rt | small (say, ≤ 0.01) and T not too big,

VT +1 ≈ V1 (1 + r1 + · · · + rT ) = V1 (1 + T avg(r))

I so high average return corresponds to high final portfolio value

I Vt ≤ 0 (or some small value like 0.1V1 ) called going bust or ruin

Portfolio investment 15
 Constant weight portfolio

I constant weight vector w, i.e., wt = w for t = 1, . . . , T

I requires rebalancing to weight w after each period
I define T × n asset returns matrix R with rows r̃tT
I so Rtj is return of asset j in period t
I then r = Rw

Portfolio investment 16
 Cumulative value plot

I assets are Coca-Cola (KO) and Microsoft (MSFT)

I constant weight portfolio with w = (0.5, 0.5)
I V1 = $10000 (by tradition)
4
x 10
3
uniform portfolio
individual assets

2.5

2
Value

1.5

0.5

0
0 500 1000 1500 2000 2500
Days

Portfolio investment 17
 Cumulative value plot

I w = (−3, 4)
I portfolio goes bust (drops to 10% of starting value)
4
x 10
3
leveraged portfolio
individual assets

2.5

2
Value

1.5

0.5

0
0 500 1000 1500 2000 2500
Days

Portfolio investment 18
 Outline

Return and risk

Portfolio investment

Portfolio optimization

Portfolio optimization 19
 Portfolio optimization

I how should we choose the portfolio weight vector w?

I we want high (mean) portfolio return, low portfolio risk

I we know past realized asset returns but not future ones

I we will choose w that would have worked well on past returns
I . . . and hope it will work well going forward (just like data fitting)

Portfolio optimization 20
 Portfolio optimization

minimize std(Rw)2 = (1/T )kRw − ρ1k2

subject to 1T w = 1, avg(Rw) = ρ

I w is the weight vector we seek

I R is the returns matrix for past returns
I Rw is the (past) portfolio return time series
I require mean (past) return ρ
I we minimize risk for specified value of return

I we are really asking what would have been the best constant
allocation, had we known future returns

Portfolio optimization 21
 Portfolio optimization via least squares

minimize kRw − ρ1k2

 T   
1 1
subject to w=
µT ρ

I µ = RT 1/T is n-vector of (past) asset returns

I ρ is required (past) portfolio return
I equality constrained least squares problem, with solution
−1 
2RT R
   
w 1 µ 2ρT µ
 z1  =  1T 0 0   1 
z2 µT 0 0 ρ

Portfolio optimization 22
 Examples

I optimal w for annual return 1% (last asset is risk-less with 1%

return)

w = (0.0000, 0.0000, 0.0000, . . . , 0.0000, 0.0000, 1.0000)

I optimal w for annual return 13%

w = (0.0250, −0.0715, −0.0454, . . . , −0.0351, 0.0633, 0.5595)

I optimal w for annual return 25%

w = (0.0500, −0.1430, −0.0907, . . . , −0.0703, 0.1265, 0.1191)

I asking for higher annual return yields
– more invested in risky, but high return assets
– larger short positions (‘leveraging’)

Portfolio optimization 23
 Cumulative value plots for optimal portfolios

cumulative value plot for optimal portfolios and some individual assets

optimal portfolio, rho=0.20/250

optimal portfolio, rho=0.25/250
individual assets

5
10
Value

4
10

0 500 1000 1500 2000 2500

Days

Portfolio optimization 24
 Optimal risk-return curve

red curve obtained by solving problem for various values of ρ

25

20
Annualized Return

15

10

0
0 10 20 30 40 50 60
Annualized Risk

Portfolio optimization 25
 Optimal portfolios

I perform significantly better than individual assets

I risk-return curve forms a straight line
– one end of the line is the risk-free asset
I two-fund theorem: optimal portfolio w is an affine function in ρ
−1  T 
2RT R
  
w 1 µ R 1
 z1  =  1T 0 0   1 
z2 µT 0 0 ρT

Portfolio optimization 26
 The big assumption

I now we make the big assumption (BA):

future returns will look something like past ones
– you are warned this is false, every time you invest
– it is often reasonably true
– in periods of ‘market shift’ it’s much less true

I if BA holds (even approximately), then a good weight vector for past

(realized) returns should be good for future (unknown) returns

I for example:
– choose w based on last 2 years of returns
– then use w for next 6 months

Portfolio optimization 27
 Optimal risk-return curve

I trained on 900 days (red), tested on the next 200 days (blue)
I here BA held reasonably well

Train
25 Test

20
Annualized Return

15

10

0
0 2 4 6 8 10 12 14 16
Annualized Risk

Portfolio optimization 28
 Optimal risk-return curve

I corresponding train and test periods

4
x 10
5

4.5

4 Train Test

3.5

2.5

1.5

0.5

0
0 500 1000 1500 2000 2500

Portfolio optimization 29
 Optimal risk-return curve

I and here BA didn’t hold so well

I (can you guess when this was?)

25 Train
Test

20

15

10
Annualized Return

−5

−10

−15

−20
0 2 4 6 8 10 12 14 16
Annualized Risk

Portfolio optimization 30
 Optimal risk-return curve

I corresponding train and test periods

4
x 10
5

4.5

4 Train Test

3.5

2.5

1.5

0.5

0
0 500 1000 1500 2000 2500

Portfolio optimization 31
 Rolling portfolio optimization

for each period t, find weight wt using L past returns

rt−1 , . . . , rt−L

variations:
I update w every K periods (say, monthly or quarterly)
I add cost term κkwt − wt−1 k2 to objective to discourage turnover,
reduce transaction cost
I add logic to detect when the future is likely to not look like the past
I add ‘signals’ that predict future returns of assets
(. . . and pretty soon you have a quantitative hedge fund)

Portfolio optimization 32
 Rolling portfolio optimization example

I cumulative value plot for different target returns

I update w daily, using L = 400 past returns
4
x 10
1.3
rho=0.05/250
rho=0.1/250
rho=0.15/250
1.25

1.2

1.15
Value

1.1

1.05

0.95
1600 1700 1800 1900 2000 2100 2200 2300 2400 2500
Days

Portfolio optimization 33
 Rolling portfolio optimization example

I same as previous example, but update w every quarter (60 periods)

4
x 10
1.3
rho=0.05/250
rho=0.1/250
rho=0.15/250
1.25

1.2

1.15
Value

1.1

1.05

0.95
1600 1700 1800 1900 2000 2100 2200 2300 2400 2500
Days

Portfolio optimization 34