What is Mean-Variance Optimization?
Basically, it is a process of choosing a set of portfolios that have the highest return for given levels of risk. Many institutional investors believe that designing the highest returning portfolio of assets cannot be done by human intuition alone. The efficient points in the Return-Risk graph are called the Efficient Frontier.
Reasons for massive adoption
- Pushed by Academics – Quantitative in Nature (appears Scientific)
- Single Solution Outcome
Some Key Issues with MVO
1. All inputted assumptions are based on historical data and are subjective.
Basically, it is garbage in, garbage out. Inputs must be solidly tested for all types of economic and political environments. There is tremendous instability in the MVO model, with regards to small changes in the input. Historic asset class returns might not be repeated in the future.
2. Underestimate Risk
Standard deviation is the only measure of risk in this model. Other types of risk must be accounted for; however, they are very difficult to model. Many investors lost big, by not looking at tail risk.
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