Efficient Portfolio Optimization in the Wealth Creation and Maximum Drawdown Space
AbstractFirst developed by Markowitz (1952), the mean-variance framework is the most widespread theoretical approximation to the portfolio problem. Nevertheless, successful application in the investment community has been limited. Assumptions such as normality of returns and a static correlation matrix could partially account for this. To overcome some of the limitations of the mean-variance framework, mainly the choice of the risk metric and the inconvenience of using an estimated correlation matrix typical of tranquil or euphoria periods, this paper proposes an alternative risk measure: the maximum drawdown (MDD), and combines it with a wealth creation measure to define a new portfolio optimization space. Like other market practitioners’ measures, MDD lacks of a complete and solid theoretical foundation. In an effort to contribute to its theoretical foundation, this paper uses common sense and financial intuition to introduce such measure, followed by a review of its technical advantages and coherence for risk management. Finally, an application of a MDD risk metric based portfolio optimization model is presented. The main findings indicate this proposal may effectively help overcome some of the traditional mean-variance shortcomings and provide some useful tools for portfolio optimization in practice. For long-term performance driven portfolios, such as pension funds, this approach may yield interesting results because it focuses on wealth creation over the long run.
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Bibliographic InfoPaper provided by Banco de la Republica de Colombia in its series Borradores de Economia with number 520.
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Portfolio Optimization; Asset Allocation; Downside Risk; Maximum Drawdown; mean-variance Criteria; Diversification. Classification JEL: G11; G23; G32; D81.;
Other versions of this item:
- Alejandro Reveiz & Carlos Eduardo León, 2008. "Efficient Portfolio Optimization in the Wealth Creation and Maximum Drawdown Space," BORRADORES DE ECONOMIA 004732, BANCO DE LA REPÚBLICA.
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Alejandro Reveiz & Carlos León & Juan Mario Laserna & Ivonne Martínez, 2008.
"Recomendaciones para la modificación del régimen de pensiones obligatorias de Colombia,"
BORRADORES DE ECONOMIA
004599, BANCO DE LA REPÚBLICA.
- Alejandro Reveiz & Carlos León & Juan Mario Laserna & Ivonne Martínez, 2008. "Recomendaciones para la modificación del régimen de pensiones obligatorias de Colombia," ENSAYOS SOBRE POLÍTICA ECONÓMICA, BANCO DE LA REPÚBLICA - ESPE.
- Alejandro Reveiz & Carlos león & Juan Mario laserna & Ivonne Martínez, . "Recomendaciones para la modificación del régimen de pensiones obligatorias de Colombia," Borradores de Economia 507, Banco de la Republica de Colombia.
- Aeljandro Reveiz Herault & Sebastian Rojas, 2008.
"The case for active management from the perspective of Complexity Theory,"
BORRADORES DE ECONOMIA
004566, BANCO DE LA REPÚBLICA.
- Alejandro Revéiz Herault & Sebastian Rojas, . "The case for active management from the perspective of Complexity Theory," Borradores de Economia 495, Banco de la Republica de Colombia.
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- Enrico De Giorgi, . "A Note on Portfolio Selection under Various Risk Measures," IEW - Working Papers 122, Institute for Empirical Research in Economics - University of Zurich.
- Alejandro Reveiz & Carlos León, .
"Administración de fondos de pensiones y multifondos en Colombia,"
Borradores de Economia
506, Banco de la Republica de Colombia.
- Alejandro Reveiz & Carlos León, 2008. "Administración de fondos de pensiones y multifondos en Colombia," BORRADORES DE ECONOMIA 004598, BANCO DE LA REPÚBLICA.
- Gregorio Impavido & Esperanza Lasagabaster & Manuel Garcia-Huitron, 2010. "New Policies for Mandatory Defined Contribution Pensions : Industrial Organization Models and Investment Products," World Bank Publications, The World Bank, number 2462, January.
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