Thursday, October 30, 2014

Portfolio decision pyramid -



The portfolio structure employed by a manager can be based on the amount of information available to the manager and his skill. If you are at the top of this pyramid and you have an information edge, then you should use it and try to maximize the Sharpe ratio of the portfolio. This means you have some idea what expected returns will be for assets included in the portfolio. If you cannot determine the direction of the market, but you can forecast or tell something about volatility and correlation between markets, then a risk parity approach or minimum variance approach may make sense. You can use the covariance matrix to help with allocation decisions. If you do not have have any idea what the correlations across markets may look like, you may want to only focus on volatility through a inverse volatility rule. This states that the correlations are all the same across assets. If you have no idea what returns or risk may look like, the best approach is to use an equal weighting strategy. Of course, if you equally weight assets from the same asset class, you will have a problem. The 1/n rule states that you have no information advantage across any part of the returns distribution.

This is a good simple way to think about portfolio construction and information advantage. Start with no knowledge and work your way up to the strong knowledge on risk and return place if you have an edge. Often times managers start at the Sharpe end of the pyramid when they belong at the equal allocation end. 

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