Financial Engineering and

Portfolio Optimization
Dr. A. Ravi Ravindran
Professor of Industrial Engineering
Pennsylvania State University
March-April 2015

Agenda
Portfolio selection problem
Diversification to reduce risk
Examples

Markowitzs Bi-criteria QP model

Example
Efficient portfolios

Sharpes Bi-criteria LP model

Asset Allocation Principles

Modern Portfolio Theory

Developed by Harry Markowitz in the
50s.
Further refined by William Sharpe in the
60s.
Both shared the Nobel Prize in
Economics in 1990 for this work.

Investment Basics
Liquidity How accessible is your
money?
Risk What is the safety involved?
Return How much profit will you
be able to expect from your
investment?
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Investment Strategies
Trade-Off between Risk and Return
Cash: the least risky with the lowest returns
Bond (Income): moderately risky with
moderate returns
Stocks (Equities): the most risky but
offering the greatest payoff

Broader diversification (Asset allocation)

reduces risk and increases return

Investing in Stocks
Stocks: Ownership shares in a
corporation
Ownership: If a company issues 1M
shares, and you buy 10,000 shares, you
own a 1% of the company.
Valuation: (1) cash dividend and (2)
share appreciation at the time of sale
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Investing in Bond
Bonds: Loans that
investors make to
corporations and
governments.
Face (par) value:
Principal amount
Coupon rate: yearly
interest payment
Maturity: the length of the
loan

Portfolio Selection Problem:

N Possible Securities (stocks, bonds, treasury
notes, banks, mutual funds, etc.)
C capital available for investment
Problem: To determine an optimal investment
policy
Decision Variables: xJ - Investment in security J,
where J=1,...,N
x1+ x2 +...+ xN <= C,
xJ >= 0 for all j

Return on Investment

Historical data for T years available

pJ ( t ) = Price of security J at the end of year t.
dJ ( t ) = Dividends/Interests paid in year t.
rJ ( t ) = Total return per dollar invested in
security J in year t.

rJ ( t )

p J ( t ) p J ( t 1) dJ ( t )
p J ( t 1)

Note: rJ (t) can be positive,negative

or zero.
Let J = Average annual return per
dollar invested in security j.
J

1 T
rJ t
T t 1

MODEL 1
(Simple Linear Programming Model)
N

MAX z = J xJ
J =1

Subject to

J =1

xJ 0
OtherConstraints : b1 x j b2
jJ

Drawbacks of the LP Model

Investment risk is ignored
No diversification ("All eggs in one
basket")
Mean values mask the variability in
returns
Illustration of Risk
Historical returns of securities

What is Risk?
Scenario 1:
Option1
Pay fixed sum of Rs. 100
Option 2
Toss a coin; if Head you get Rs. 1000; if
Tail, you get nothing
Which option would you prefer?

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What is Risk (Continued)

Scenario 2:
Option1
Pay fixed sum of Rs. 100
Option 2
Toss a coin; if Head you get Rs. 2000; if
Tail, you have to pay me Rs. 1000.
Which option would you prefer now?

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20 Year Returns from Various

Investment Securities (1993-2012)
Average Annual
Return

Best Year

Worst year

U.S. Stocks

8.2%

37.5%
(1995)

-22%
(2002)

International
Stocks

6.1%

38.6%
(2003)

-21.4%
(2001)

90-day US
Treasury bills

3.2%

6.3%
(2000)

0.1%
(2012)

U.S. Bonds

6.3%

18.5%
(1995)

-1.0%
(1999)

Markowitzs Mean Variance Model

Diversify the portfolio to reduce risk
Variance of security returns
Correlations between returns

Investment Risk in Security j

Variance of return from its average value
2

2
JJ

1 T
rJ t J
T t 1

Risk due to Correlation of Returns

between Securities
Securities in similar industries such as auto, utilities
etc. would rise and fall together
General impact of economy
Interest rate changes

ij2 = Covariance of return between securities

i and j

1 T
rI t i rJ t j
T t 1
2
ij

Matrix Q = [qij] = [2ij]: an NxN variancecovariance matrix of returns

Excel Functions
Variance:
VAR(A1:A10)
Here, T=10 years and A1 to A10 contain
annual returns over 10 years for security A

Covariance
COVAR(A1:A10,B1:B10)
Gives the covariance of the returns
between securities A and B

Correlations With US Stocks

(1998-2008)

Foreign Stocks:
Emerging Markets:
Commodities:
Government Bonds:
(Long Term)

0.87
0.79
0.19
-0.16

Impact of Diversification
Example 1
Mix of bonds and stocks

Example 2
Mix of high risk stock categories

Markowitz models for portfolio risk

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Impact of Diversification:
Example 1
PORTFOLIOS(Stock/Bond)
Year Stock

Bond

1(0/100) 2(25/75) 3(50/50) 4(75/25) 5(100/0) 6(5/95) 7(10/90)

30.00%

10.00% 10.00%

15.00%

20.00%

25.00%

30.00%

11.00% 12.00%

30.00%

0.00%

7.50%

15.00%

22.50%

30.00%

1.50%

3.00%

-10.00%

10.00% 10.00%

5.00%

0.00%

-5.00%

-10.00% 9.00%

8.00%

-10.00%

0.00%

0.00%

-2.50%

-5.00%

-7.50%

-10.00% -0.50% -1.00%

Mean 10.00%

5.00%

5.00%

6.25%

7.50%

8.75%

10.00%

5.25%

5.50%

STD

5.77%

5.77%

7.22%

11.90%

17.38%

23.09%

5.61%

5.69%

23.09%

0.00%

Impact of Diversification: Example 1

(contd..)
Efficient Frontier
12.00%
10.00%

Return

8.00%
Series1

6.00%
4.00%
2.00%
0.00%
0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

Standard Deviation

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Impact of Diversification:
Example 2
U.S. stock performance (1979 2008)
Average Annual
Return

Standard
Deviation

Large Cap stocks

(S&P 500)

11%

17%

Mid/Small cap stocks

(Russell 2500)

12%

20.7%

International stocks
(MSCI EAFE)

9.4%

19%

Diversified Portfolio
60% Large cap, 20%
Mid/small cap, 20%
International

11.1%

16.5%

Source: T.Rowe Price

Markowitzs Mean Variance Models

for Portfolio Selection
Single objective Quadratic
Programming Model
Minimize Risk for a certain minimum return

Bi-criteria Optimization Model

Minimize Risk
Maximize Return

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Quadratic Programming Model (Model 2)

Minimize variance of portfolio
N

xT Qx qIJ xI xJ
I 1 J 1

Subject to

J 1

x J Ret

+ Other Constraints
Ret = Minimum portfolio return required

Bi-Criteria Model: (Model 3)

Combines the LP model which maximizes
return and the QP model which minimizes
risk.

Minimize Risk (Portfolio Variance)

= xTQx
Maximize average Annual Return
N

J xJ T x
J 1

In general, there will be no portfolio which

simultaneously maximizes return and
minimizes risk.
Need for a "trade-off" analysis.

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RISK - RETURN CURVE

Efficient
Portfolios
RETURN

Maximize return

Feasible
Portfolios

Minimize risk

RISK

EFFICIENT PORTFOLIO:
An efficient portfolio or investment plan is such
that there exists no other plan which has
A higher return with no greater risk
or
The same return with a lesser risk
PROBLEM: Determine all the efficient
portfolios from which to choose from.

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Markowitzs Bi-criteria Model: Example 3

An investment company can invest in three
stocks. From past data, the means and
standard deviations of annual returns have
been estimated as shown in Table 1. The
correlations between the annual returns on
the stocks are listed in Table 2.
Table 1 Means & Std. deviations

Table 2 Correlations

Stock 1

Means
0.14

STDEV
0.20

Stocks 1 & 2

Correlation
0.6

Stock 2

0.11

0.15

Stocks 1 & 3

0.4

Stock 3

0.10

0.08

Stocks 2 & 3

0.7

Markowitzs Bicriteria Model:

Example 3 (contd..)
The company has $100,000 to invest with the following
requirements:
(i) No more than 50% should be invested on any stock.
(ii) Invest all $100,000 among the three stocks.
(iii) Invest at least $10,000 each in stocks 1 and 3.
(iv) Achieve maximum portfolio return.
(v)
Achieve minimum portfolio variance.
a) Formulate the above problem as a bicriteria problem.
b) Reformulate the problem if the objective were to find a
minimum variance portfolio that yields an average portfolio
return of at least 12%.

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Markowitzs Bicriteria Model:

Example 3 - Solution
a) Let xi = $ invested in stock i, i=1, 2, 3. The bicriteria math
programming model is the following,
Max z1 = 0.14x1 + 0.11x2 + 0.10x3

(Maximize portfolio return)

Min z2 = xtQx = 0.04x12 + 0.0225x22 + 0.0064x32 + 0.036x1x2 +

0.0128x1x3 + 0.0168x2x3

(Minimize portfolio variance)

Subject to:
(No more than 50% invested in any stock)
(Invest all $100,000)
x1 x 2 x 3 100 ,000
x 1 10 , 000 x3 10,000 (Invest at least $10,000 each in stocks 1 and 3)
(Non-negativity)
xi 0 for i 1, 2 ,3
x i 50 ,000 for i 1, 2 ,3

Markowitzs Bicriteria Model:

Example 3 Solution (contd..)
Note: The variance-covariance matrix is given by Q=
0.04

0.018 0.0064
0.018 0.0225 0.0084

0.0064 0.0084 0.0064

b) The formulation remains the same, except that the
objective function, Max z1, is now converted to a constraint
as follows:

0.14x1 0.11x2 0.10x3 12,000

Note: By varying the minimum return (RHS) and solving each

QP problem, we can generate the entire efficient frontier

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Example 3 Markowitzs QP Model Solutions

Lower
limit on
return
12000
11750
11500
11250
11000
10870

Return
(%)
12.00%
11.75%
11.50%
11.25%
11.00%
10.87%

Risk
(%)
12.17%
11.54%
11.05%
10.70%
10.53%
10.500%

Harry Markowitz (1950) developed the

Quadratic Programming Model.
Drawback: Lot of data collection due to QP
Model. Need (NxN) matrix of N(N+1)/2
elements.
Extension by William Sharpe (1963).
Concept of Market Risk for each security.
Showed price fluctuations of securities are
correlated with stock market performance.
Hence, covariance with respect to a broad
market index is sufficient to capture the
investment risk.
Used Standard & Poor 500 Stock Index.

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Market Risk of a Security

Let j = Beta risk of security j representing the
market risk.
Beta for S&P 500 = 1.0
For security J, j = 1.3 means it is 30% more
volatile than the market.
Requires only N elements to compute as
opposed to N(N+1)/2 for Markowitz's model.

Market Indices
Measures trends in performance of
stocks and bonds

Dow Jones Industrial Average

Standard & Poor 500 Index
Russell 2000 Index
NASDAQ
Morgan Stanley EAFE Index
Barclays Bond Index

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2012 Market Returns

DJIA
S&P 500
Russell 2000
EAFE Index
NASDAQ
Barclays Bond Index
Cash (90-day T-Bills)

7.3%
15.3%
16.4%
17.9%
15.9%
4.2%
0.1%

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Model 4: (Sharpes Bi-criteria LP Model)

Achieve portfolio diversification by mixing low beta with
high beta securities
N

Portfolio Risk = J x J T x
J =1

Now the portfolio selection or asset allocation problem

becomes
Minimize Portfolios Beta Risk
Maximize Portfolio Return
+Other investment constraints
Both Objectives are linear and we have a Bi-criteria
Linear Program!

Sharpe Ratio = Return per unit of risk

SJ

J T
J

T= Average return from a "safe" investment

(e.g. Treasury bills with zero risk)
J - T = Excess Return over no risk
investment
Model 5:
N

Max z S J x J
J 1

+ other investment restrictions

This is a single objective LP model!

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Security Returns
Average Return (Statistical)
Annualized Return (Compounded)
Illustrative Example
Google stock

Uses

Google Stock
Went public on Aug. 2004
Annual returns
2005: 115%; 2006: 11%; 2007: 50%
2008: -56%; 2009: 102%; 2010: -4%;
2011: 9%; 2012: 10%; 2013: 58%

For 2005-2013 (9 years):

Average annual return: 33%
Compounded annualized return: 22%

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Investment Strategies
Creating a Diversified Portfolio

Advice on Selecting Stocks for

Investment
I try to buy stock in businesses that are
so wonderful that an idiot can run them.
Because, sooner or later, one will
-------Warren Buffet

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Asset Allocation
Equities, Bonds and Cash
Equities
US Stocks
Large, Medium and Small Cap
Growth and Value

International Stocks
Developed Countries
Emerging Markets

Real Estate

Bonds
Long, Intermediate, Short Term
Government, Corporate and High Yield

Asset Allocation/Portfolio
Selection
Allocation of investment funds in
Equities, Bonds and Cash.
Two conflicting objectives
Maximize Return
Minimize Risk

More than 90% of portfolios

performance is tied to asset allocation
strategies

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Asset Allocation: Illustrations

Historical Performance of Asset
Classes
Annual Returns (1993-2012)

Impact of Diversification
20-Year Return (1993-2012)

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Impact of Diversification
(20-Year Returns, 1993-2012)
Average Annual
Return

Standard
Deviation

Large Cap stocks (S&P 500)

8.2%

15.1%

Mid/Small Cap Stocks (Russell 2000)

8.4%

19.6%

International Stocks (MSCI-EAFE)

6.1%

17.0%

Bonds (Barclays Bond Index)

6.3%

3.7%

Cash (T-bills, 90 days)

3.2%

0.6%

Diversified Portfolio
45% Large Cap, 10% mid/small cap,
10%International and 35% bonds)

7.9%

9.9%

Investment Advice
Set up an Emergency fund to cover
6 months of living expenses.
Save at least 10% of your net pay
each month, beginning with the first
pay check.
Pay your credit card balances in
FULL at the end of each month.

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Investment Advice (Contd.)

Follow the Golden Rule of investment:
BUY LOW AND SELL HIGH
To achieve this, follow Dollar Cost
Averaging strategy: Invest a fixed
amount at regular intervals (monthly

Use the Birthday Rule for asset

allocation: Own your age in bonds

Investment Advice (Contd.)

Check your portfolios asset
allocation twice a year. Make
adjustments if necessary.
Do not pay attention to the daily
ups and downs of the stock market.
You are in for the long haul. RELAX
and enjoy your investment grow!

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Modern Portfolio Theory

References:
Heching, A.R. and A.J. King, Financial Engineering,
Chap. 21, Operations Research and Management
Science Handbook, A. Ravi Ravindran (Ed.), CRC
Press, 2008.
Reklaitis, Ravindran, and Ragsdell, (2006).
Engineering Optimization, Wiley, Second Edition, New
York, pp. 494-498.
Markowitz, H. M., (1952). "Portfolio Selection", J. of
Finance, Vol. 12, 77-91.
Markowitz, H. M., (1956). "The optimization of a
Quadratic Function Subject to Linear Constraints",
Naval Res. Log. Qtly, Vol.3, 111-133.

Modern Portfolio Theory

References: (cont..)
Markowitz, H. M., (1959). Portfolio Selection,
Efficient Diversification of Investments, Wiley,
New York,.
Sharpe, W. F., (1963). "A simplified Model for
Portfolio Analysis", Management Science, 9(2),
277-293.

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