Portfolio Construction Models

No sensible decision can be made any longer without taking into account not only the world as it is, but the world as it will be.

—Isaac Asimov

The goal of a portfolio construction model is to determine what portfolio the quant wants to own. The model acts like an arbitrator, hearing the arguments of the optimist (alpha model), the pessimist (risk model), and the cost-conscious accountant (transaction cost model), and then making a decision about how to proceed. The decision to allocate this or that amount to the various holdings in a portfolio is mostly based on a balancing of considerations of expected return, risk, and transaction costs. Too much emphasis on the opportunity can lead to ruin by ignoring risk. Too much emphasis on the risk can lead to underperformance by ignoring the opportunity. Too much emphasis on transaction costs can lead to paralysis because this will tend to cause the trader to hold positions indefinitely instead of taking on the cost of refreshing the portfolio.

Quantitative portfolio construction models come in two major forms. The first family is rule based. Rule-based portfolio construction models are based on heuristics defined by the quant trader and can be exceedingly simple or rather complex. The heuristics that are used are generally rules that are derived from human experience, such as by trial and error.

The second family of quantitative portfolio construction models is optimized. Optimizers utilize algorithms—step-by-step ...

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