Hidden Risks in Mean-Variance Optimization: An Integrated-Risk Asset Allocation Proposal

José Luiz Barros Fernandes and Jose Ornelas

Chapter 6 in Interest Rate Models, Asset Allocation and Quantitative Techniques for Central Banks and Sovereign Wealth Funds, 2010, pp 112-133 from Palgrave Macmillan

Abstract: Abstract The traditional mean—variance asset allocation approach (Markowitz 1952) considers the volatility of returns as the only risk factor. However, investors are usually concerned about other types of risk or negative statistical properties of returns. For instance, investors usually care about credit and liquidity risks, and the skewness and kurtosis of returns. Thus, there is a risk premium embedded in their returns to compensate for additional risk taking. If those risk premia are not taken into account in the analysis, the results of the model tend to be distorted, with portfolios carrying these hidden risks dominating the risk-free portfolios. Moreover, the resulting portfolios for the traditional model tend to be badly behaved due to the overconfidence on the risk/return estimation. Black and Litterman (1992) realize that quantitative asset allocation models have not played the important role they should in global portfolio management, partly due to the previous problems.

Keywords: Full Sample; Credit Risk; Portfolio Optimization; Hedge Fund; Excess Return (search for similar items in EconPapers)
Date: 2010
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DOI: 10.1057/9780230251298_6

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