Portfolio Optimization Theory vs. Practice

This paper examines the gap between the theory of portfolio construction and its practice. In particular, it analyzes some of the problems in the application of portfolio optimization techniques to individual investors. We then discuss what can be done today to compensate for the problems with the theory, and what additional work needs to be accomplished.

Various books and articles have discussed some of the problems with Modern Portfolio Theory, which is the basis for most portfolio optimizers. This article compiles that information into a critique of the investment industry’s continued reliance on portfolio optimization tools.

Clients and investment professionals alike place far too much faith in the mathematics of portfolio optimization techniques and the recommendations that result from applying optimization techniques to clients’ portfolios. Clients will benefit from being more aware of the very substantial gap between asset allocation theory and the real world. Portfolio construction is mostly an art, not a science. Investment success depends upon experience, judgment, skill, and luck—the latter often showing up as fortuitous timing. Clients should avoid relying too much upon the seemingly precise construction of “optimum” portfolios and risk measurements produced by portfolio optimization tools.

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