Mean Portfolio Variance Optimization

Posted on March 25, 2008 by Dr. David Edward Marcinko MBA MEd CMP™

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MPT and the Efficient Frontier

By Dr. David Edward Marcinko; MBA, CMP™

[Publisher-in-Chief]

fp-book3Mean Portfolio Variance Optimization [MPVO] has at its core Modern Portfolio Theory (MPT), which seeks to find the “efficient frontier” that defines the minimum risk for any given level of investment portfolio rate-of-return.  

Efficient Frontier 

In order to find the efficient frontier, MPVO will consider the expected returns, standard deviations (i.e., volatility) and correlation coefficient of individual asset classes within a physician or other investor’s portfolio. 

All things being equal, the physician or endowment fund manager would generally choose investments with the highest expected long-term return.  

However, the current funding needs placed upon endowments, or in personal portfolios, may require that they be sensitive to the volatility of asset classes. These restrictions are the stuff of MPVO. 

Risk of Expected Volatility 

Expected portfolio volatility is often defined as “risk” and measured by the standard deviation of investment returns around an expected average return for that same investment.  

In other words, an asset class with an expected return of 10% and standard deviation of 5% would have its returns range from 5% to 15% approximately two-thirds of the time. 

Two MPVO Types 

  • In conventional single period MPVO, a doctor will make his portfolio allocation for a single upcoming period [time-certain], and the goal will be to maximize expected arithmetic return subject to a selected level of risk.  
  • In multi-period MPVO, a doctor will be concerned with strategies in which the portfolio is rebalanced to a specified allocation at the end of each period.

Such a strategy is sometimes called Constant Proportion (CP), or Constant Ratio Asset Allocation (CRAAL).  The goal is to maximize the true multi-period (geometric mean) return for a given level of fluctuation.  

Assessment 

MPVO is the quantitative assessment which facilitates portfolio asset allocation by considering the trade-off between risk [expected volatility] versus return [arithmetic or geometric]*. 

* Geometric mean is the n-th root of the product of n numbers – unlike an arithmetic mean – it tends to dampen the effect of very high or low values which might bias the mean if a straight average (arithmetic mean) were calculated.

And so, do you consider MPT and MPVO [which type] when constructing your own investment portfolio? Why or why not? 

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Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

OUR OTHER PRINT BOOKS AND RELATED INFORMATION SOURCES:

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2 Responses

  1. Brendon, on November 8, 2009 at 7:36 PM said:

    Dr. Marcinko

    As your ME-P readers are aware, there have been two major declines over the past eight years, and the stock market is on pace to underperform every decade over the past century, including the 1930s.

    During this time, modern portfolio theory [MPT] represented the investment methodology most widely employed by financial advisors. It mandated a strategy of allocating funds to a wide array of asset classes in an effort to lower risk. The goal was to identify low or even negatively correlated assets that would allow a portfolio to withstand the most severe declines. But, I’m not so sure the theory has worked; do you?

    Incidentally, I do enjoy the counter-cultural ideology of this blog, and own all your books and texts. What’s next-up on your publishing radar, if anything?

    Thanks.
    Brendon

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  2. Dr. Marcinko, on November 9, 2009 at 11:10 AM said:

    Brendon,

    Some believe that the zealot-like use of MPT is just a risk reduction mechanism. As you may know, the rendered care in medicine need not always correct; but it must be within a given standard-of-care for the involved specialty [major opinion or significant minority standard]. So, if all FAs blindly use MPT, isn’t their systemic risk of industry malpractice [EO liability] reduced, if not eliminated?

    IOW: It’s not my fault if we all got poor results.

    And, the SOC for FAs, brokers, CFPs® and many others in the retail advisory space may be considered very low indeed. That’s why we started the online http://www.CertifiedMedicalPlanner.org program in health economics and medical management for physician focused niche advisors. You see, Certified Medical Planners™ must be fiduciaries at all times, and at least be college graduates – still unfortunately a high watermark for far too many folks providing financial advice today.

    Oh! Thanks for the kind words.

    Dave Marcinko
    [Publisher-in-Chief]

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