2 An Introduction to Portfolio Construction
This chapter covers
- Creating risk-reward plots
- Using matrix operations to compute portfolio returns and volatilities
- Calculating, plotting, and deriving the math behind the efficient frontier
- Introducing a risk-free asset and the idea of the Capital Allocation Line
- Gauging an investor’s risk tolerance through questionnaires
- Using slider widgets to help an investor visualize the risk-reward tradeoff
One of the primary functions of a robo-advisor is to construct a well-diversified portfolio of assets. In this chapter and the two chapters that follow, we will provide the theoretical foundation for portfolio construction and all the building blocks that will be needed. We will also start using Python in our examples. Later in the book, we will delve deeper into the topic of portfolio construction including some problems with the traditional methods that are covered in this chapter.
Let's start off with a simple example with only three assets, First Energy (FE), Walmart (WMT), and Apple (AAPL). The analysis that follows can always be generalized to include as many assets as you would like. And in this example, the assets are individual stocks, but they could easily be bonds, ETFs, commodities, cryptocurrencies, or even hedge funds. The problem we want to address is what are the optimal weights to assign to these three assets. We will start off by taking the approach of the Nobel Prize-winning work of Harry Markowitz.