CHAPTER 10
Selecting among Efficient Portfolios and Making Dynamic Rebalancing Adjustments
Modern academic approaches to portfolio selection typically have started with the bedrock question of how investors evaluate and choose among the uncertain consumption—or cash flow—streams represented by differing investment securities. This is the conceptual equivalent to what is referred to in other areas of finance and econometrics as a structural model. For our purposes as practitioners, we may utilize a method that is similar to what finance and econometric specialists call a reduced-form approach. With this approach, we do not dig all the way down to the foundation. Rather, we assume that tractable, mathematical rules for choosing among portfolios are given and that such rules are reasonably consistent with observable value-maximizing behavior by investors.
Our reduced-form ranking method can be typified by the general equation form shown in equation (10.1),
where
U = a measure of portfolio desirability
R = expected portfolio return
σ = portfolio risk as measured by standard deviation
e = base of the natural logarithm
K, ε, and α = positive, scaling constants
The relationship between portfolio desirability and expected return is reflected in the partial derivative of U with respect to R.
The mathematical meaning of this partial derivative is that increasing expected return, ...
