Portfolio Performance: Naïve vs. Optimized
Using historical return data from January 1994 to August 2009, we calculated the performance of a portfolio of securities employing two models: naïve diversification, and optimized diversification. The portfolio consisted of 11 carefully selected and diverse domestic and international securities (see exhibit 1), and we assumed no change in the allocations throughout the entire period measured for both the naïve and optimized models. Each model generated very different results, and this section will explain the performance differences between each. When developing a naively diversified portfolio, an equal weight is given to each asset with little consideration given to the degree of correlation each individual asset has with one another. Exhibit 4 shows the correlational relationships between each security within the portfolio. As can be seen, each asset exhibits a different degree of movement with the other assets in the portfolio. Although the portfolio is diversified in the sense that it includes several different domestic and international assets, the correlational measurements between the assets show areas where additional risk can be eliminated by weighting additional resources to certain assets. When using a naïve allocation strategy this benefit is lost. Even though the returns may seem attractive for a naïve portfolio, they come at the cost of additional risk and lower performance (see exhibit 1). Given our objective of longevity and sustained returns, it is our responsibility to ensure that the maximum return is maintained with as little exposure to risk as possible. Through Markowitz’s model of portfolio selection, we can achieve optimum results from a diversified portfolio by method of efficient diversification. Markowitz’s model involves finding the portfolio weights for a diversified set of assets that will result in the steepest capital allocation line. Increasing the steepness of the CAL...
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