What are the main meanings of Portfolio theory
portfolio theory
the study of the way in which an individual investor may theoretically achieve theAs part of the continuing series on Modern Portfolio Theory, we will providing weekly updates to track our model portfolio’s performance. As illustrated below, we will be tracking the performance of three portfolios.
Two of these portfolios will be optimized based on the theory of mean variance optimization (Markowitz’s Modern Portfolio Theory) and one is allocated based on a traditional approach of a mix between equity and debt. At the beginning of each week we invest $1,000 based on the allocation of the three portfolios and compare the results at the end of trading on Friday. Check back often to see how the optimized portfolio’s fared!
For an easy-to-follow guide for building the optimized portfolios in R based on Markowitz’s Modern Portfolio Theory (mean variance optimization), please refer to Chapter 5 in the series.
Portfolio Composition
The table below summarizes the three tracking portfolios, as of May 28, 2013, using data from the past two years.
Portfolio | SPY | EFA | IWM | VWO | LQD | HYG | Std.Dev | Exp.Return | sharpe |
---|---|---|---|---|---|---|---|---|---|
Optimized – Short Selling & No Max | 0.87 | -0.13 | -0.22 | -0.33 | 0.62 | 0.18 | 0.0035 | 0.0006 | 0.18 |
Optimized – No Shorting & 75% Max | 0.15 | -0.00 | -0.00 | -0.00 | 0.75 | 0.10 | 0.0032 | 0.0003 | 0.10 |
Traditional | 0.30 | 0.20 | 0.15 | 0.10 | 0.15 | 0.10 | 0.0106 | 0.0003 | 0.03 |
As can be quickly gleamed from the table, both optimized portfolios have a much higher Sharpe Ratio. The Sharpe Ratio is the portfolio’s return over its standard deviation and can be used as one measure of performance. The higher the Sharpe ratio, the higher the return to the portfolio’s variance. A high return coupled with a low Sharpe ratio could imply that the returns were achieved with too much risk–a potential indication of volatile returns in the future. (Of course, past performance is no guarantee of future performance and correlations between the securities can quickly change.)