Portfolio Optimization Through Risk Allocation and Diversification
Summary
The document distinguishes two portfolio problems: choosing investments and sizing a group of trading strategies. For multiple strategies believed to be profitable and reasonably uncorrelated, one answer suggests allocating capital in inverse proportion to each strategy’s volatility. It adds that accounting for correlations calls for a more involved approach, such as equal risk contribution, which can be calculated in a spreadsheet.
For broader investment decisions, the answers emphasize understanding and accepting portfolio risk, diversifying, reducing transaction costs, taxes, and management fees, and using the market portfolio as a benchmark or starting point. The discussion gives examples of methods but no performance evidence or worked comparison. Its suggestions are starting points, not guarantees of an optimal allocation: the inverse-volatility rule is presented for strategies that are reasonably uncorrelated, while the more complex approach requires correlation estimates. The original question is also ambiguous about whether it concerns stock selection or combining trading strategies.
Key ideas
- Inverse-volatility allocation gives a larger capital share to lower-volatility strategies when the strategies are reasonably uncorrelated.
- Accounting for correlations can require an equal-risk-contribution allocation.
- Investors should understand and accept the risks in their portfolio.
- Diversification, low costs, and limited unnecessary trading are presented as broad portfolio principles.
- The market portfolio can serve as a practical benchmark or starting point.
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Full text
# Optimizing Investment Portfolio
# Optimizing Investment Portfolio
I might be interested in optimizing an stock investment portfolio. With or without using programming, is there an article I should refer to optimize my portfolio and help me taking good investment decision?
## Answer by Sanjay (score 2)
https://quant.stackexchange.com/a/44205
What does it mean that you will optime portfolio "without programming"? Does that mean that you will do calculations by hand???
Articles will not help you since every article you will be able find is based on optimization models in which market data will somehow be involved. That you cannot do "without programming".
Maybe you should think about finding online models where someone else have done the programming part for you. Look for instance at:
https://www.portfoliovisualizer.com/optimize-portfolio#analysisResults
This is a simple Mean-Variance model you can read about here: https://www.math.ust.hk/~maykwok/courses/ma362/Topic2.pdf
or less technical: https://www.effisols.com/basics/MVO.htm
## Answer by nbbo2 (score 2)
https://quant.stackexchange.com/a/44232
The scope of your question is quite unclear to me.
You seem to mention trading. If you have multiple trading strategies (that you think are good, and reasonably uncorrelated) and you want to trade them as a portfolio,
a commonly used criterion is to allocate capital to each strategy in proportion to the inverse of the strategy's standard deviation. So if for example your Strat1 has $\sigma$ of 10% a year and Strat2 has $\sigma$ of 20%, you would allocate (1/0.1)(1/0.1+1/0.2) = 2/3 of your capital to Strat1 and the remaining 1/3 to Strat2.
This is the simplest optimization you can do and it can be done on the back of an envelope. If you want to get fancier you would need to know the correlations among the strategies, then you can calculate an ERC (Equal Risk Contribution) solution, which can be done in a spreadsheet.
On the other hand, if you just want to help me tak[e] good investment decisions then you don't really need optimisation and calculations. The insights of Portfolio Theory can be summarized as:
(0) Make sure you know the risk(s) of your portfolio and that you are comfortable with those risks (not too much, not too little).
(1) Make sure your portfolio is well diversified ("diversification is the only free lunch")
(2) Minimize transaction cost, taxes and management costs. In particular ignore the advice of Wall Street, CNBC etc.; they just want you to transact, to be always buying and selling, because it is in their interest. Only trade as needed. ("Your portfolio is like a bar of soap, the more you touch it the less you will have")
(3) The Market Portfolio, while not necessarily optimal, is probably close to the theoretically optimal portfolio and can serve as a reasonable starting point and benchmark.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.