Question

Practical portfolio optimization can be summarized as "finding optimal portfolio weights for available investment assets that would minimize risk while maximizing returns given investor’s risk aversion”. However, pure portfolio optimization suffers from a flaw–it gives a lot of weight to the assets (stocks, ETFs, bonds, etc) that performed well recently.

Explain why this is a flaw.

Identify some practical solutions that could mitigate this flaw.

Answer 1

Optimal portfolio- It is a portfolio with mix of investment alternatives so as to minimize the risk and maximize the return. Optimal portfolio is made by taking shares, ETFs and bonds in a proportion.

Why it is a flaw?

It is a flaw because all the given asset; shares, ETFs and bonds are having risk, shares have risk of price fluctuation, ETFs have market risk, bonds have default risk, credit rating risk and interest rate risk. People who are not risk averse persons, cannot take that much risk.

Practical solutions to mitigate this flaw- Portfolio should have Government securities and fixed income securities that have no or less risk as compare to stocks, ETFs and bonds. Government securities and fixed income provide fixed and regular return, these are good for the people who cannot take risk.