Portfolio optimization via linearly constrained least-squares.
We consider a universe of financial assets, in which we seek to invest over one time period. We denote by the vector containing the rates of return of each asset. A portfolio corresponds to a vector , where is the amount invested in asset . In our simple model, we assume that ‘‘shorting’’ (borrowing) is allowed, that is, there are no sign restrictions on .
As explained, the return of the portfolio is the scalar product . We do not know the return vector in advance. We assume that we know a reasonable prediction of . Of course, we cannot rely only on the vector only to make a decision, since the actual values in could fluctuate around . We can consider two simple ways to model the uncertainty on , which result in similar optimization problems.
Mean-variance trade-off.
A first approach assumes that is a random variable, with known mean and covariance matrix . If past values of the returns are known, we can use the following estimates
Note that, in practice, the above estimates for the mean and covariance matrix are very unreliable, and more sophisticated estimates should be used.
Then the mean value of the portfolio’s return takes the form , and its variance is
We can strike a trade-off between the ‘‘performance’’ of the portfolio, measured by the mean return, against the ‘‘risk’’, measured by the variance, via the optimization problem
where is our target for the nominal return. Since is positive semi-definite, that is, it can be written as with , the above problem is a linearly constrained least-squares.
An ellipsoidal model
To model the uncertainty in , we can use the following deterministic model. We assume that the true vector lies in a given ellipsoid , but is otherwise unknown. We describe by its center and a ‘‘shape matrix’’ determined by some invertible matrix :
We observe that if , then will be in an interval , with
Using the Cauchy-Schwartz inequality, as well as the form of given above, we obtain that
Likewise,
For a given portfolio vector , the true return will lie in an interval , where is our ‘‘nominal’’ return, and is a measure of the ‘‘risk’’ in the nominal return:
We can formulate the problem of minimizing the risk subject to a constraint on the nominal return:
where is our target for the nominal return, and . This is again a linearly constrained least-squares. Note that we obtain a problem that has exactly the same form as the stochastic model seen before.