Mean–Variance Optimization for Asset Allocation

Abstract

The mean–variance model is widely acknowledged as the foundation of portfolio allocation because it provides a framework for analyzing the trade-off between risk and return for gaining diversification benefits. Despite the well-known shortcomings of the model, it is often the starting point for making asset allocation decisions. In this article, the authors briefly review mean–variance optimization and approaches for resolving its limitations by demonstrating backtest results on asset allocation. Feedback from asset managers is also included to explain how optimization methods are applied in practice.