- Adaptive Asset Allocation (AAA) is based on the Nobel Prize winning portfolio theory of Markowitz (1952)
- AAA combines asset’s momentum, volatilities, and cross-correlations for building diversified investment portfolios
- In a tactical application AAA exploits momentum for crash detection and results in consistent returns at mitigated risk levels
Actually, their encounter was coincidental. The fortuitous conversation between a stockbroker and a young mathematician in the early 1950’s proved to be seminal. After the stockbroker learned about the mathematician’s expertise, linear programming and utility maximization, and its real-life applications, he suggested to apply the math to financial portfolios. Fast-forwarding four decades, in 1990 Harry Markowitz shared the Nobel Prize in Economics for his pioneering work on Modern Portfolio Theory (MPT).
 |
Matrix rain animation courtesy TheCodePlayer.
AniGif created with Gif Brewery.
|
The mathematical framework of MPT combines asset’s expected returns, volatilities, and cross-correlations for assembling well-balanced and diversified portfolios while maximizing the expected return for a given level of risk. Its key proposition: for a multi asset portfolio returns can be maximized for a given level of risk. Likewise, risk can be minimized for a desired level of return. With the efficient frontier as its famous graphical depiction (see graph below), Markowitz’ MPT is also known as “mean-variance analysis” since the “mean” or expected return is maximized given a certain level of risk, defined as the portfolio variance (which is volatility squared).
Efficient Frontier
MPT proposes a mathematical framework how investors can reduce overall risk while maximizing return by holding a diversified portfolio of non-correlated asset classes. Instead of looking at the risk-return characteristics of each single asset class, MPT assesses risk and return as cumulative factors for the portfolio as a whole. The Markowitz Efficient Frontier is the graphical depiction of the collection of portfolios that offer the lowest risk for a given level of return. In an excellent video Arif Irfanullah explains in merely 3 minutes how the efficient frontier represents the set of portfolios that will give the highest return at each level of risk or the lowest risk for each level of return (highly recommended).
To illustrate key elements of MPT, let’s bring to bear the top selection from a diversified investment universe SPY, EWJ, VGK, EEM, and DBC (both the full universe population as well as the selection methodology are explained in the next section).
The portfolio concept under consideration for this contribution is the long only minimum variance portfolio without leverage, located at the magenta dot on the outer left side of the purple portfolio cloud (see statistics in bold font in the table below the following graph). For this special case portfolio risk is minimized for all feasible long only combinations. To localize this particular portfolio an Adaptive Asset Allocation (AAA) approach is applied. Please note the purple long only portfolio cloud is only a subset of the full unconstrained long/short portfolio space demarcated by the blue portfolio envelop hyperbola.
Speed readers may jump to the next section, others please bear with me while painting the full picture.
