Models of Investment - ZISHI

Models of Investment

Article published in Advice Matters Magazine – Edition 01/2023

In a previous Advice Matters article, we discussed the important subject of investment models. In this article we will look in more detail at some more of the most popular models, their uses, attractions and of course their potential limitations:

    • Mean Variance Optimisation

    • Risk Parity

    • Constant Proportion Portfolio Insurance (CPPI).

Mean Variance Optimisation

The invention of Harry Markowitz in the 1950’s, MVO forms the bedrock of what is still, to this day, called Modern Portfolio Theory.

Previously, portfolio managers largely relied on their intuition or ‘stock picking’ skills to deliver the best return they could possibly achieve for their clients. The downside of this approach was that sometimes this resulted in portfolios that were too concentrated around the best performing companies or sectors of the day. As a result, if there was a downturn in those sectors, or even the market in general, the portfolio would suffer large losses.

Using mathematics, Modern Portfolio Theory (MPT) introduced the concept of an efficient portfolio: the combination of available assets that provides the highest risk adjusted return.
Using the inputs of:

    • the return and

    • the risk of each component part of the portfolio ‘universe’ and

    • their correlation to the other components of the portfolio

it is possible to calculate the total risk and return represented by all of the possible portfolio combinations.

For each level of risk there will be a portfolio that provides the highest return. By plotting these portfolio combinations, it will produce an ellipse which is known as the efficient frontier.

There will be one portfolio on the efficient frontier that provides the highest risk adjusted return (Sharpe Ratio). This is called the market portfolio or optimal portfolio.

Diagram: Position of the optimal portfolio on the efficient frontier

Diagram: Position of the optimal portfolio on the efficient frontier

When a risk-free asset is added, further combinations are possible. Instead of investing all of the money in risky assets the investor can keep some money in the risk-free asset and invest some in the market portfolio (the optimal portfolio combination of risky assets). This may suit investors who do not wish to take the amount of risk represented by the optimal portfolio (less adventurous investors).

Assuming that borrowing could take place at the risk-free rate, there are more investment opportunities to the right of the market portfolio which would involve investing more than 100% in the market portfolio. This may suit more adventurous investors who can accept a higher degree of risk in return for the potential to make higher returns.

The issues with MVO centre on the sensitivities of the optimal weights to the input estimations. Depending on the review frequency, this could lead to considerable rebalancing costs which could severely affect returns. Another potential drawback is that risk is calculated by standard deviation which assumes a normal ‘bell shaped’ distribution around the mean. In practice investments tend to be negatively skewed meaning that the impact of potential losses can be underestimated.

This approach may be suitable where a client is happy to bear long term risk and continue through ups and downs. However, MVO may not be appropriate where a client has a minimum portfolio value that needs to be maintained.

Risk Parity

Proponents of this model believe that a traditional asset allocation approach of having a greater exposure to equities than bonds (for example 70/30 or even 60/40) is akin to putting too many of your eggs in your riskiest basket. (…)

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