Risk-Based Approaches to Asset Allocation: Concepts and by Maria Debora Braga

By Maria Debora Braga

This publication makes a speciality of the techniques and functions of risk-based asset allocation. Markowitz’s conventional method of asset allocation suffers from severe drawbacks whilst applied. those normally come up from the estimation threat linked to the mandatory enter the main serious being anticipated returns. With the monetary difficulty, there was an expanding curiosity in asset allocation methods that don’t desire anticipated returns as enter, referred to as risk-based methods. The booklet presents an research of the several options that healthy this description: the equal-weighting technique, the worldwide minimum-variance technique, the main various portfolio technique and the chance parity procedure. as well as a theoretical dialogue of those, it offers sensible functions in numerous funding environments. 3 assorted overview dimensions are thought of to place those methods to the try out: monetary potency, diversification and portfolio stability.

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It is well-known this condition does not apply to all the other optimal portfolios on the Efficient Frontier which are strongly dependent also on the expected returns estimates. This is the reason why the global 3 See Elton et al. (2014), Fabozzi et al. (2007), Gilli et al. (2011). For clarity, we remember that since standard deviation is a “derivative” of variance (it is simply its square root), using the conventional approach of minimizing the portfolio variance leads actually to the minimum volatility portfolio.

2 The Theoretical Background and Argument … 23 while the single marginal risk is defined as follows: MRr ðRwÞi ffi ¼ pffiffiffiffiffiffiffiffiffiffiffi w0 Rw i ð3:16Þ where ðRwÞi denotes the ith row of the column vector resulting from the product of Σ with w. 2 Since the strategy relies on the risk allocation argument as opposed to the traditional dollar allocation, at this point we need to conclude giving evidence, as remarked by Qian (2005, 2011), that seemingly well-diversified or well-balanced allocations can hide concentrated risk exposures.

Given that leverage means to be financed, we have to acknowledge that, in extreme market conditions, the roll-over of loans is subject to uncertainty and/or the possibility to be forced to execute distressed sales because of significant changes of the borrowing rates and of the assets value. Furthermore, it can be taken for granted that leverage not only amplifies returns, it also exacerbates losses and the impact of tail events. To conclude, it is important to emphasize that we share the idea of levered risk parity portfolio adopted by Qian (2011), that is leverage applied to the entire “source” portfolio.

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