The Equation Everyone in Finance Show Know, but Many Probably Don’t!
… With thanks to codecogs.com which makes it really easy to write equations for the web.
This simple matrix equation is extremely powerful. This is really two equations. The first is all you really need. The second is just merely there for illustrative purposes.
This formula says how the variance of a portfolio can be computed from the position weights wT = [w1 w2 … wn] and the covariance matrix V.
- σii ≡ σi2 = Var(Ri)
- σij ≡ Cov(Ri, Rj) for i ≠ j
The second equation is actually rather limiting. It represents the smallest possible example to clarify the first equation — a two-asset portfolio. Once you understand it for 2 assets, it is relatively easy to extrapolate to 3-asset portfolios, 4-asset portfolios, and before you know it, n-asset portfolios.
Now I show the truly powerful “naked” general form equation:
This is really all you need to know! It works for 50-asset portfolios. For 100 assets. For 1000. You get the point. It works in general. And it is exact. It is the E = mc2 of Modern Portfolio Theory (MPT). It at least about 55 years old (2014 – 1959), while E = mc2 is about 99 years old (2014 – 1915). Harry Markowitz, the Father of (M)PT simply called it “Portfolio Theory” because:
There’s nothing modern about it.
Yes, I’m calling Markowitz the Einstein of Portfolio Theory AND of finance! (Now there are several other “post”-Einstein geniuses… Bohr, Heisenberg, Feynman… just as there are Sharpe, Scholes, Black, Merton, Fama, French, Shiller, [Graham?, Buffet?]…) I’m saying that a physicist who doesn’t know E = mc2 is not much of a physicist. You can read between the lines for what I’m saying about those that dabble in portfolio theory… with other people’s money… without really knowing (or using) the financial analog.
Why Markowitz is Still “The Einstein” of Finance (Even if He was “Wrong”)
Markowitz said that “downside semi-variance” would be better. Sharpe said “In light of the formidable
computational problems…[he] bases his analysis on the variance and standard deviation.”
Today we have no such excuse. We have more than sufficient computational power on our laptops to optimize for downside semi-variance, σd. There is no such tidy, efficient equation for downside semi-variance. (At least not that anyone can agree on… and none that that is exact in any sense of any reasonable mathematical definition of the word ‘exact’.)
Fama and French improve upon Markowitz (M)PT [I say that if M is used in MPT, it should mean “Markowitz,” not “modern”, but I digress.] Shiller, however, decimates it. As does Buffet, in his own applied way. I use the word decimate in its strict sense… killing one in ten. (M)PT is not dead; it is still useful. Diversification still works; rational investors are still risk-averse; and certain low-beta investments (bonds, gold, commodities…) are still poor very-long-term (20+ year) investments in isolation and relative to stocks, though they still can serve a role as Markowitz Portfolio Theory suggests.
Wanna Build your Own Optimizer (for Mean-Return Variance)?
This blog post tells you most of the important bits. I don’t really need to write part 2, do I? Not if you can answer these relatively easy questions…
- What is the matrix expression for computing E(Rp) based on w?
- What simple constraint is w subject to?
- How does the general σp2 equation relate to the efficient frontier?
- How might you adapt the general equation to efficiently compute the effects of a Δw event where wi increases and wj decreases? (Hint “cache” the wx terms that don’t change,)
- What other constraints may be imposed on w or subsets (asset categories within w)? How will you efficiently deal with these constraints?
- Is short-selling allowed? What if it is?
- OK… this one’s a bit tricky: How can convex optimization methods be applied?
If you can answer these questions, a Part 2 really isn’t necessary is it?