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Intermediate
Mathematical optimization is the selection of a best result of a function among a variety of alternative results. The optimal solution is selected by altering values within a range to find the desired maximum or minimum of a function. These ranges are often called constraints or bounds in the optimization function. Optimization is used in computer science, operational research and in financial applications.
Synonyms: portfolio optimization, MVO optimization, optimisation
For context, an application in the financial realm requiring optimization is the process of portfolio optimization. Here the outcome is the selection of portfolio weights to assets based on the maximization of a ratio of return over risk, like the Sharpe Ratio for example. This type of optimization is often called MVO for Mean/Variance Optimization which is a key component of Modern Portfoio Theory.
In that equation, the numerator 'Mean' stands for the forecast return based on weights times forecast return. The denominator 'Variance' stands for the forecast variance for the ending portfolio. This optimization incorprates two measure of risk: variance and covariance. The calculation takes into consideration the benefits of risk-lowering diversification by utilizing an asset-by-asset or factor-based covariance matrix.
Portfolio optimization is often an iterative process of reviewing inputs and setting constraints such as turnover, industry bounds and risk explsures to achieve the desired portfolio weights. A rebalance frequency refers to how often a financial optimization is performed.
Optimization is typically performed using specialized risk analysis software and third-party risk models. Alternatively, for simple cases optimization in Excel can be performed using the Solver Add-In provided with a subscription to Excel.
Kim: At my job I do SEO. Search Engine
Optimization. What do you do again?
Guy: I do MVO. It's portfolio
optimization. I've heard SEO is more difficult.
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False. It requires the Solver Add-In.
True. Many seasoned portfolio managers iterate through various optimization scenarios before finalizing a trade list.
Still unclear on the topic of Optimization? Check out our financial modeling series called Quant 101.
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