Portfolio Management Tool: How Does it Work?

hon (1)
The AP on the Street

Portfolio Management Tool: How Does it Work?

Our Portfolio Manager tool is the best way for portfolio managers to test their strategies efficiently without spending too much time. Our tool utilizes Markowitz’s portfolio theory to perform calculations and give suggestions to increase a portfolio’s Sharpe ratio. 

Markowitz’s portfolio theory (MPT) is a method that risk-averse investors can use to construct diversified portfolios that maximize their returns without unacceptable levels of risk. The theory was pioneered by Harry Markowitz in 1952 in his paper “Portfolio Selection,” for which he later received a Nobel Prize.

The main idea of MPT is that the risk and return of a portfolio should not be evaluated by the individual characteristics of each asset but by how they affect the overall portfolio. An investor can reduce risk by choosing investments that do not move exactly together or have low or negative correlations. This is called diversification.

MPT uses mathematical tools such as variance and correlation to measure the risk and return of a portfolio. The expected return of a portfolio is calculated as a weighted sum of the returns of each asset, while the standard deviation or volatility of the portfolio returns measures the risk. MPT also introduces the concept of the efficient frontier, which is the set of portfolios that offer the highest return for a given level of risk or the lowest risk for a given level of return. Investor can choose their optimal portfolio from the efficient frontier based on their risk preference and utility function.

To implement MPT, an investor needs to follow these steps:
  1. Identify the set of possible assets to invest in and estimate their expected returns and risks.
  2. Calculate the correlations between each pair of assets and construct a correlation matrix.
  3. Use an optimization technique such as quadratic programming to find the optimal weights for each asset that maximizes the expected return for a given level of risk or minimizes the chance for a given level of return.
  4. Plot the efficient frontier and select the best portfolio according to the investor’s utility function.

MPT has some limitations and criticisms, such as relying on historical data and assumptions that may not hold in reality, ignoring taxes and transaction costs, and being sensitive to input errors. However, it is still widely used by most financial institutions.