Efficient Portfolio Optimization in the Wealth Creation and Maximum Drawdown Space

INTEREST RATE MODELS, ASSET ALLOCATION AND QUANTITATIVE TECHNIQUES FOR CENTRAL BANKS AND SOVEREIGN WEALTH FUNDS, A. Berkelaar, J. Coche, K. Nyholm, eds., Palgrave Macmillan, 2010

23 Pages Posted: 16 Sep 2009 Last revised: 3 Oct 2010

See all articles by Carlos León

Carlos León

Tilburg University - Center for Economic Research (CentER); Financial Network Analytics Ltd

Date Written: June 15, 2008

Abstract

First 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.

Keywords: Portfolio Optimization, Asset Allocation, Downside Risk, Maximum Drawdown, mean-variance Criteria, Diversification

JEL Classification: G11, G23, G32, D81

Suggested Citation

León, Carlos, Efficient Portfolio Optimization in the Wealth Creation and Maximum Drawdown Space (June 15, 2008). INTEREST RATE MODELS, ASSET ALLOCATION AND QUANTITATIVE TECHNIQUES FOR CENTRAL BANKS AND SOVEREIGN WEALTH FUNDS, A. Berkelaar, J. Coche, K. Nyholm, eds., Palgrave Macmillan, 2010, Available at SSRN: https://ssrn.com/abstract=1473595 or http://dx.doi.org/10.2139/ssrn.1473595

Carlos León (Contact Author)

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Financial Network Analytics Ltd ( email )

London
United Kingdom

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