Porfolio Construction

Overview

In the abstract, portfolio construction is about maximizing some objective (like total returns) while controlling for risk. The difficulty come when trying to precisely define what this means and constructing a process around it.

Risk Based Approaches

It is a well known statistical fact that it easier to forecast return variance than the expected return. (For example, it is pretty easy to guess what the average volatility of teh SP500 will be over the next year. Not so easy to guess where it will end up.)

Based on this forecast difficulty, many strategies have been devised that are based solely on the factor that can be reasonably measured, the risk.

• Equally Weighted
• Minimum Variance
• Risk Budgeting (and Risk Parity)
• Diversity

Forecast Based Approaches

Forecast based portfolio construction starts with a set of asset forecasts. These forecasts need not be precise return forecasts, they could be be simply labels such as "buy" and "sell". Next, the portfolio construction will build a portfolio that that utilizes the the asset forecasts with at least a minimal risk constraint to build an optimal portfolio.

• Trader Techniques and Risk Budgeting: examines techniques traders have traditionally used to build a portfolio based on their forecasts while also controlling for risk.
• Mean Variance
• Utility Based
• Benchmarked (Active Risk)

Multi-Period Considerations

Many portfolio frameworks are stated in terms of returns over a single period. When applied to multiple periods, it is common to just maximize the portfolio each period based on the single period framework.

The following topics address some of the issues that can arise when multiple trading periods are taken into consideration.

• Growth Optimal Portfolios
• Optimal Control

Practical Considerations

Practical Considerations : when building a portfolio using quantitative methods, it is important to keep some praciticalities in mind.