Variance Penalty In Portfolio Optimisation
Volatility is naughty
Welcome back my friends.
In case one day any of us would ever want to apply to WorldQuant, let's talk a bit more about portfolio optimisation. Better be ready than not. Today we gonna talk about a cute trick in portfolio optimisation, that is derived from first principles, very simple, comes at the cost of no extra parameter, and also has a beautiful interpretation. I'm overselling it but it is what it is your boy gotta make that bread. Let's get it.
In @_paleologo's book: Advanced Portfolio Management, he wrote about an interesting experiment:
He showed that misestimation of expected returns for a low volatility asset is more detrimental than misestimation of expected returns for a high volatility asset. And we all know that vanilla MVO has a tendency to load up on low volatility assets.
Just by this observation, we will work our way into implementing a remedy to this issue. Let's dive in.