Modern Asset Allocation for Wealth Management

CHAPTER 5Portfolio Optimization

Step 4 of four in our asset allocation process brings us to our crowning moment: running an optimizer to produce portfolios that respect nuanced client preferences while simultaneously being robust to estimation error. The chapter begins with a review of our optimizer results as a function of our three-dimensional client risk profile space, showcasing an intuitive evolution of portfolios as our three preference parameters change. We then spend time contrasting our framework with other potential solutions to elucidate the value of our three-dimensional risk preference utility functions. The chapter ends with a review of the sensitivity of our recommended portfolios to estimation error, as we deploy the bootstrap method to create error bars on each asset's recommended allocation.

Key Takeaways:

1. Our modern utility function results in an intuitive three-dimensional landscape of optimized portfolios that is rich in behavioral content.
2. The three-dimensional utility function is a critical requirement for systematic incorporation of financial goals into a PT-conscious asset allocation framework, even when higher moments are not meaningful.
3. The error bars on our optimizer's recommended portfolio allocations are large but manageable, highlighting the importance of always minimizing estimation error and its consequences.
4. Our asset allocation error bars go down as we expand our outcome forecasting sample size, and as we limit redundancy of asset classes, ...