Unit-3 Pseudo Efficiency Complete PDF

Portfolio Optimization
Unit 3: Classical Mean Variance Model Revisited:

Pseudo Efficiency
Duan LI & Xiangyu Cui
India Institute of Technology Kharagpur
May 26 - 30, 2014
Outline
Literature and Introduction
Inverse Problem of Mean-Variance Formulation
Pseudo Efficiency
Type 1 and Best Investment Performance
Type 2 and Optimal Management of Initial Endowment
Conclusions
1 / 34
Outline
Pseudo Efficiency
Conclusions
1 / 34
Outline
Pseudo Efficiency
Conclusions
1 / 34
Outline
Pseudo Efficiency
Conclusions
1 / 34
Literature and introduction

!
Markowitz(1952) introduced seminal work on mean-variance

portfolio selection which laid the foundation for modern financial
analysis and led a remarkable development of a return-risk portfolio
selection framework.
Tobin(1958) revealed the famous mutual fund theorem that the

optimal portfolio of a mean-variance optimizer is a combination of a
riskless asset and a risky fund.
Sharp(1964), Lintner(1965) and Mossin(1966) introduced the

capital asset pricing model, independently, using different
approaches.
Black(1972) discussed the equilibrium of a capital market allowing

short selling and without riskless asset or with restricted borrowing.
Merton(1972) derived the analytic expression of efficient solutions

for the unconstrained mean-variance portfolio selection.
2 / 34

!



approaches.


2 / 34

!



approaches.


2 / 34

!



approaches.


2 / 34

!



approaches.


2 / 34
Mean-Variance Model with All Risky Assets

Consider the following classical mean-variance portfolio selection problem
in a market of n risky assets with a total random return vector,
r = (r1 , r2 , . . . , rn )! , of which the first and second order moments are
known as e = E (r ), V = Cov (r ):
(MV )
min
x
s.t.
1 !
x Vx
2
x ! e = ,
x ! 1 = x0 ,
(1)
where x0 is an initial wealth level which is assumed to be positive and

is the pre-given expected wealth level.
If we normalize x0 to 1, (MV ) becomes the mean-variance model
originally studied by Markowitz(1952), except that we allow short selling
here in (MV ).
3 / 34
Derivation of the optimal policy

!
By introducing two Lagrangian multipliers, 1 and 2 , we form the

following Lagrangian function:
L=
1 !
x Vx + 1 (x ! e ) + 2 (x ! 1 x0 )
2
Optimality conditions:
Vx + 1 e + 2 1 = 0, x = V 1 (1 e + 2 1)
B
A
x ! e = , e ! V 1 e1 1! V 1 e2 =
x ! 1 = x0 , e ! V 1 11 1! V 1 12 = x0 .
"!
" !
"
!
"
!
"!
"
1 C
A
1
1
A
=
C
2
x0
2
A B
x0
D
4 / 34

(Contd)
It can be verified that the optimal portfolio of (MV ) is given by
x0
x(x0 ; ) = (BV 1 1 AV 1 e) + (CV 1 e AV 1 1),

D
D
(2)
where
A = 1! V 1 e = e ! V 1 1,
B = e ! V 1 e > 0,
C = 1! V 1 1 > 0,
D = BC A2 > 0.
The positiveness of D can be seen from the positiveness of
(Ae B1)! V 1 (Ae B1) = BD (Merton(1972)).
A fact that has not been fully recognized in the literature is that
parameter A can be positive, negative or zero.
5 / 34
Derivation of the minimum variance set
= x ! (x0 ; )Vx(x0 ; )
x0
= [ (BV 1 1 AV 1 e) + (CV 1 e AV 1 1)]!

D
D
x0
[ (B1 Ae) + (Ce A1)]

D
D
1
2
=
(CD 2ADx0 + BDx02 )
D2
#
$2
C
A
x2
=
x0 + 0 .
D
C
C
6 / 34

(Contd)
The minimum variance set of problem (MV ) can be expressed as
C
=
D
2
A
x0
C
$2
x02
.
C
(3)
As the mean-variance pair of the minimum variance portfolio (MVP) is

A
x2
given as ( x0 , 0 ), the upper branch of the minimum variance set,
C
C
#
$2
C
A
x2
A
2
{(, ) | =
x0 + 0 , x0 },
D
C
C
C
constitutes the so-called mean-variance efficient frontier.
7 / 34

(Contd)
We denote all portfolio policies corresponding to the mean-variance pairs
on the minimum variance set of problem (MV ) boundary policies, which
could be either efficient or inefficient.
More specifically, the set of efficient boundary policies, denoted by X e ,
and the set of inefficient boundary policies, denoted by X ie , can be
expressed explicitly as follows:
Xe
X ie
A
x0 },
C
A
= {x(x0 ; ) | x(x0 ; ) is given in (2), < x0 }.
C
= {x(x0 ; ) | x(x0 ; ) is given in (2),
8 / 34
Dual realization of a mean-variance pair

We are interested in solving an inverse problem to find out which initial
wealth level enables us to achieve a given mean-variance pair, (, ), in
the mean-variance space by adopting a boundary portfolio policy.
Solvingx0 from (3) yields the following two solutions when condition
| | B holds:
%
A + D(B 2 2 )
+
x0 =
,
(4)
% B
A D(B 2 2 )
x0 =
.
(5)
B
Clearly, x0+ and x0 represent two initial endowment levels which can
achieve the given pair of (, ), where x0+ x0 holds whenever B 2
2 and they are equal only when B 2 = 2 . Note that any pair (, )
that does not satisfy | | B is not achievable.

9 / 34
Reachable Region
The reachable region in the mean-variance space is defined as
{(, ) | | | B}.
!
All interior points within the reachable region in the mean-variance

space can be realized by adopting one of the two boundary portfolio
policies associated, respectively, with two different initial wealth
levels.
Any boundary point of the reachable region in the mean-variance

space is generated by a single boundary portfolio policy associated
with one specific initial wealth level.
The minimum variance sets associated with different initial wealth

levels of x0 form a family of hyperbolas. i) When A is positive,
decreasing the level of x0 moves the hyperbola downwards; and ii)
When A is negative, decreasing the level of x0 moves the hyperbola
upwards.
10 / 34
Reachable Region
{(, ) | | | B}.
!

levels.


upwards.
10 / 34
Reachable Region
{(, ) | | | B}.
!

levels.


upwards.
10 / 34
Reachable Region
{(, ) | | | B}.
!

levels.


upwards.
10 / 34
Reachable Region (Contd)
Part A
Part B
Part C
Figure: The reachable region and its partition

11 / 34
Reachable Region (Contd)

!
The upper branch of the reachable region: = B, is tangent to

the efficient frontier associated with initial investment x0 :
&
'2 x 2
C
0
{(, ) | 2 = D
CA x0 + C0 , CA x0 }, at Bx
A .
The set of all mean-variance pairs associated with the minimum
variance portfolio policies corresponding to different initial wealth
levels is given by
|A|
{(, ) | = },
C
where {(, ) | =
|A|
}
C
represents all minimum variance points
} represents
with positive expected returns and {(, ) | = |A|
C
all minimum variance points with negative expected returns.
12 / 34
Partition of Reachable Region

!
Part A:
Part B:
|A|
{(, ) | < B}.
C
Every point in Part A is achieved by two efficient boundary portfolio
policies corresponding to two different initial wealth levels.
|A|
|A|
{(, ) | < },
C
C
Any point in Part B is achieved by one efficient boundary portfolio
policy and one inefficient boundary portfolio policy corresponding to
two different initial wealth levels. When A = 0, part B vanishes.
Part C:
|A|
{(, ) | B < < }.
C
Every point in Part C is achieved by two inefficient boundary
portfolio policies.
13 / 34

!
Part A:
Part B:
|A|
{(, ) | < B}.
C
|A|
|A|
{(, ) | < },
C
C
Part C:
|A|
{(, ) | B < < }.
C
portfolio policies.
13 / 34

!
Part A:
Part B:
|A|
{(, ) | < B}.
C
|A|
|A|
{(, ) | < },
C
C
Part C:
|A|
{(, ) | B < < }.
C
portfolio policies.
13 / 34
Pseudo Efficiency
Outline
Pseudo Efficiency
Conclusions
14 / 34
Pseudo Efficiency
Pseudo Efficiency (Type 1)

If the investment performance is measured by a mean-variance pair, the
common assumption that the higher endowment the better does not hold.
Definition
If an efficient mean-variance pair of problem (MV ) associated with initial
endowment x0 can be also generated or even dominated by another
mean-variance pair generated by another boundary portfolio policy
associated with initial wealth x0 which is strictly less than x0 , i.e.,
C
(, [
D
x0 < x0 ,
A
x0
C
$2
x2
C
+ 0 ]) ' (
, [
C
D
#
$2
A
x2
x0 + 0 ]),
C
C
(6)
(7)
then, the given mean-variance pair associated with endowment x0 is

termed pseudo efficient (type 1) and the corresponding efficient boundary
portfolio policy x(x0 ; ) is called pseudo efficient policy (type 1).
15 / 34
Pseudo Efficiency
Pseudo Efficiency (Type 1) (Contd)

!
In other words, if a mean-variance efficient solution of (MV ) with

respect to a given initial wealth level x0 becomes inefficient in an
expanded three dimensional objective space:
{min (initial wealth level), max (expected future wealth),
min (variance of the future wealth)}, it is pseudo efficient.
One important recognition from our earlier discussion on dual

realization
( & is that,'for any given mean-variance pair
2
x2
C
(, D
CA x0 + C0 ) in the interior of the reachable region,
there exists another initial wealth level x0 such that
x0 + x0 =
2A
B
(8)
and (6) becomes an equality.

16 / 34
Pseudo Efficiency

Proposition
When x0 > 0 and A > 0, all mean-variance pairs within
)
#
$2
C
A
x2
A
B
{(,
x0 + 0 ) | x0 x0 }
D
C
C
C
A
are pseudo efficient (type 1).
When x0 > 0 and A < 0, all efficient mean-variance pairs of (MV ),
) #
$2
C
A
x2
A
{(,
x0 + 0 ) | x0 }
D
C
C
C
Remark
Set { |
A
C x0
B
A x0 }
is non-empty as D = BC A2 > 0.
17 / 34
Pseudo Efficiency
Markowitzs Example
For this market of three risky assets with expected return vector
e = (1.162, 1.246, 1.228)!
and covariance,
0.0146 0.0187 0.0145

V = 0.0187 0.0854 0.0104 ,
0.0145 0.0104 0.0289
the corresponding parameters are A = 8.0602, B = 9.3568, C = 6.9846,

and D = 0.3872.
18 / 34
Pseudo Efficiency
Markowitzs Example (Continued)

!
We consider an instance with investors initial wealth level equal to

1 and the pre-given expected return equal to = 1.160, which is
greater than CA x0 = 1.154 and less than BA x0 = 1.1609.
Furthermore, the optimal efficient portfolio is specified by

x(x0 = 1; = 1.16) = (1.1075, 0.0471, 0.0296)!
and the corresponding efficient mean-variance pair is given by
(1.160, 0.0719).
From (8) and Proposition 3.2, it can be verified that the following
boundary policy associated with a less initial wealth x0 = 0.9985,
x(
x0 = 0.9985, = 1.16) = (0.9914, 0.0404, 0.0475)!
yields the same mean-variance pair of (1.160, 0.0719).
Thus, x(x0 = 1; = 1.16) is pseudo efficient.

19 / 34
Pseudo Efficiency
Best Investment Performance

We now consider the following revised formulation of problem (MV ) by
allowing investors the flexibility not to invest all his money into the
market,
(MV1 )
min
x
s.t.
1 !
x Vx
2
x ! e = ,
x ! 1 x0 ,
(9)
where the initial wealth level, x0 , and the pre-set expected wealth level,
, are both assumed to be positive.
20 / 34
Pseudo Efficiency
Best Investment Performance (Contd)

Proposition
The optimal portfolio policy of (MV1 ) is given as,
x (
x0 ; ) =
x0
(BV 1 1 AV 1 e) + (CV 1 e AV 1 1),

D
D
(10)
where x0 is the optimal investment amount invested into the market,

.
x0 ,
A > 0 and > BA x0 ,
x0 =
(11)
A
B , otherwise.
Furthermore, the mean-variance efficient frontier of (MV1 ) is given by
/ (
D 2
CD2 x02 + CA x0 , A > 0 and > BA x0 ,
=
(12)
C
B,
otherwise,
which is a continuous function.
21 / 34
Pseudo Efficiency

Hint of the proof: Solving problem (MV1 ) is equivalent to solving a
two-phase optimization problem: Finding first the optimal initial
investment level x0 from the following formulation,
#
$2
C
A
x2
min
x0 + 0 ,
(13)
x0 x0
D
C
C
and applying then the efficient mean-variance policy x (
x0 ; ).
!
When A < 0, the efficient frontier of problem (MV1 ) is exactly the

upper boundary of the reachable region. In other words, all efficient
solutions in the traditional mean-variance sense are essentially
pseudo efficient (type 1).
When A > 0, the efficient frontier of problem (MV1 ) is a

combination of the lower segment of the upper boundary of the
reachable region and the upper segment of the efficient frontier of
problem (MV ) with initial wealth x0 .
22 / 34
Pseudo Efficiency

#
$2
C
A
x2
min
x0 + 0 ,
(13)
x0 x0
D
C
C
x0 ; ).
!


22 / 34
Pseudo Efficiency

#
$2
C
A
x2
min
x0 + 0 ,
(13)
x0 x0
D
C
C
x0 ; ).
!


22 / 34
Pseudo Efficiency
MVP
Figure: The efficient frontier of (MV1 ) with A > 0

23 / 34
Pseudo Efficiency
Outline
Pseudo Efficiency
Conclusions
24 / 34
Pseudo Efficiency
Optimal Management of Initial Endowment

Consider the following revised mean variance model for the optimal
management of the total endowment,
(MV2 )
max
x
s.t.
x ! e + (x0 x ! 1)
1 !
x Vx = 2 ,
2
x ! 1 x0 ,
(14)
where the initial wealth level, x0 , is assumed to be positive and zero

interest is assumed to be applied to the money the investor places aside
at time 0.
25 / 34
Pseudo Efficiency
Optimal Management of Initial Endowment

(Contd)
Proposition
The optimal portfolio policy of (MV2 ) is given as,
!"
#
x02
x0
2
A
2
1
1
x (
x0 ; ) = (BV 1AV e)+
2 +
x0 (CV 1 eAV 1 1),
D
CD
C D
CD
(15)
where
$
x0 ,
if A > C and 2 > BA x0 ,
%
x0 =
(16)
C
(A C ) D+(AC )2 , otherwise.
Furthermore, the mean-variance efficient frontier of (MV2 ) can be expressed as,
%
)2 2
D 2
CD2 x02 + CA x0 , A > C and 2 > D+(AC

2 C x0 ,
C
(AC
)
%
=
(17)
x + D+(AC )2 ,
otherwise.
0
C
26 / 34
Pseudo Efficiency
Efficient Frontiers of (MV ), (MV1) and (MV2)
MVP
Figure: Efficient frontiers of (MV ), (MV1 ) and (MV2 ) when A > C

27 / 34
Pseudo Efficiency
Efficient Frontiers of (MV ), (MV1) and (MV2)
MVP
MVP
(a) A C and A > 0
(b) A < 0
Figure: Efficient frontiers of (MV ), (MV1 ) and (MV2 )

28 / 34
Pseudo Efficiency
Pseudo Efficiency (Type 2)

Definition
If an efficient mean-variance pair of problem (MV ) associated with initial
&
'2 x 2
C
endowment x0 , (, D
CA x0 + C0 ), is not pseudo efficient (type 1),
but is dominated by the efficient mean-variance pair of problem (MV2 ),
i.e.,
#
$2
C
A
x2
(, [
x0 + 0 ]) ' ((x )! e + (x0 (x )! 1), 2 ), (18)
D
C
C
where x is the optimal policy of (MV2 ) given in (15), then the given
mean-variance pair associated with endowment x0 is called pseudo
efficient (type 2) and the corresponding efficient boundary portfolio
policy x(x0 ; ) is called pseudo efficient policy (type 2).
29 / 34
Pseudo Efficiency

Proposition
i) There is no type-2 pseudo efficient mean-variance pair when A < 0.
ii) When x0 > 0 and 0 < A C, all mean-variance pairs within
) #
$2
C
A
x2
B
{(,
x0 + 0 ) | x0 }
D
C
C
A
iii) When x0 > 0 and A > C, all mean-variance pairs within
)
#
$2
C
A
x2
B
D + (A C )2
{(,
x0 + 0 ) | x0 (1 +
)x0 }
D
C
C
A
(A C )C
30 / 34
Pseudo Efficiency
Markowitzs Example
Applying the two revised mean variance formulations, (MV1 ) and (MV2 ),
to the Markowitzs example yields the efficient frontier of (MV1 ) as
.
0.0554 2 0.0079 + 1.1540, > 1.1609,
=
3.0589,
0 1.1609,
and the efficient frontier of (MV2 ) as
.
0.0554 2 0.0079 + 1.1540, > 1.2055,
=
1 + 0.4702,
0 1.2055.
It can be seen that the mean variance pairs in
{(, 18.0388( 1.1540)2) + 0.1432) | 1.1540 1.1609} are pseudo
efficient (type 1) and the mean variance pairs in
{(, 18.0388( 1.1540)2) + 0.1432) | 1.1609 1.2055} are pseudo
efficient (type 2).
31 / 34
Pseudo Efficiency
Markowitzs Example (Contd)
1.22
1.21
1.2
1.19
1.18
1.17
1.16
MVP
1.15
1.14
1.13
0.26
0.28
0.3
0.32
0.34
0.36
0.38
0.4
0.42
0.44
0.46
Figure: Efficient frontiers of (MV ), (MV1 ) and (MV2 ) for Markowitzs

market setting
32 / 34
Conclusions
Conclusion
!
Since Markowitz published his seminal work on mean-variance

portfolio selection in 1952, almost all literature in the past half
century adhere their investigation to a budget constraint assumption
on this classical investment issue. In the mean-variance world for a
market of all risky assets, however, the common belief of
monotonicity does not hold, i.e., not the larger amount you invest,
the larger expected future amount you can expect for a given risk
(variance) level.
We examine this classical problem from an expanded three-objective

framework: Maximizing the expected terminal wealth, minimizing
the risk (variance) of the terminal wealth and minimizing the initial
investment level.
33 / 34
Conclusions
The concept of pseudo efficiency is introduced to remove the

set of portfolio policies which are efficient in the original
mean-variance space, and are, however, inefficient in this newly
introduced three-dimensional space.
By relaxing the binding budget spending constraint in

investment, we derive an optimal scheme in managing initial
endowment which dominates the traditional mean-variance
efficient frontier.
Reference: Cui, X. Y., Li, D., & Yan, J. A. (2013). Classical

Mean Variance Model Revisited: Pseudo Efficiency. To appear
in Journal of Operational Research Society. Also available at
http://ssrn.com/abstract=1507453.
34 / 34

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Portfolio Optimization

Unit 3: Classical Mean Variance Model Revisited:

Literature and Introduction

Literature and introduction

Markowitz(1952) introduced seminal work on mean-variance

Tobin(1958) revealed the famous mutual fund theorem that the

Sharp(1964), Lintner(1965) and Mossin(1966) introduced the

Black(1972) discussed the equilibrium of a capital market allowing

Merton(1972) derived the analytic expression of efficient solutions

Literature and Introduction

Literature and introduction

Markowitz(1952) introduced seminal work on mean-variance

Tobin(1958) revealed the famous mutual fund theorem that the

Sharp(1964), Lintner(1965) and Mossin(1966) introduced the

Black(1972) discussed the equilibrium of a capital market allowing

Merton(1972) derived the analytic expression of efficient solutions

Literature and Introduction

Literature and introduction

Markowitz(1952) introduced seminal work on mean-variance

Tobin(1958) revealed the famous mutual fund theorem that the

Sharp(1964), Lintner(1965) and Mossin(1966) introduced the

Black(1972) discussed the equilibrium of a capital market allowing

Merton(1972) derived the analytic expression of efficient solutions

Literature and Introduction

Literature and introduction

Markowitz(1952) introduced seminal work on mean-variance

Tobin(1958) revealed the famous mutual fund theorem that the

Sharp(1964), Lintner(1965) and Mossin(1966) introduced the

Black(1972) discussed the equilibrium of a capital market allowing

Merton(1972) derived the analytic expression of efficient solutions

Literature and Introduction

Literature and introduction

Markowitz(1952) introduced seminal work on mean-variance

Tobin(1958) revealed the famous mutual fund theorem that the

Sharp(1964), Lintner(1965) and Mossin(1966) introduced the

Black(1972) discussed the equilibrium of a capital market allowing

Merton(1972) derived the analytic expression of efficient solutions

Literature and Introduction

Mean-Variance Model with All Risky Assets

where x0 is an initial wealth level which is assumed to be positive and

Literature and Introduction

Derivation of the optimal policy

By introducing two Lagrangian multipliers, 1 and 2 , we form the

Literature and Introduction

Mean-Variance Model with All Risky Assets

x(x0 ; ) = (BV 1 1 AV 1 e) + (CV 1 e AV 1 1),

Literature and Introduction

Derivation of the minimum variance set

= [ (BV 1 1 AV 1 e) + (CV 1 e AV 1 1)]!

[ (B1 Ae) + (Ce A1)]

Literature and Introduction

Mean-Variance Model with All Risky Assets

As the mean-variance pair of the minimum variance portfolio (MVP) is

Literature and Introduction

Mean-Variance Model with All Risky Assets

Inverse Problem of Mean-Variance Formulation

Dual realization of a mean-variance pair

that does not satisfy | | B is not achievable.

Inverse Problem of Mean-Variance Formulation

All interior points within the reachable region in the mean-variance

Any boundary point of the reachable region in the mean-variance

The minimum variance sets associated with different initial wealth