Encyclopedia of Financial Models III

Robust Portfolio Optimization

DESSISLAVA A. PACHAMANOVA, PhD

Associate Professor of Operations Research, Babson College

PETTER N. KOLM, PhD

Clinical Associate Professor and Director of the Mathematics in Finance Masters Program, Courant Institute, New York University

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

SERGIO M. FOCARDI, PhD

Partner, The Intertek Group

Abstract: As the use of quantitative techniques has become more widespread in the investment industry, the issue of how to handle portfolio estimation and model risk has grown in importance. Robust optimization is a technique for incorporating estimation errors directly into the portfolio optimization process, and is typically applied in conjunction with robust statistical estimation methods. The robust optimization approach uses the distribution from the estimation process to find a portfolio allocation in one single optimization, while keeping the computational costs low. Robust portfolios tend to be less sensitive to estimation errors, offer some improved portfolio performance, and often have lower turnover ratios.

The concepts of portfolio optimization and diversification have been instrumental in the understanding of financial markets and the development of financial decision making. The major breakthrough came in 1952 with the publication of Harry Markowitz's theory of portfolio selection. Markowitz suggested that sound financial decision making is a quantitative trade-off between ...