Part 3 Portfolio construction

In this part of the book, we’ll discuss methods for determining “optimal" portfolio weights. Chapter 10 shows how to estimate expected returns and covariances, as well as other constraints or considerations, to build optimized portfolios using convex optimization. We’ll also highlight some of the pitfalls associated with using optimization to build portfolios.

The next two chapters discuss methodologies designed to address these pitfalls. Chapter 12 covers the Black–Litterman model, which allows investors to express their opinions about the expected returns of various asset classes while anchoring their expectations to ones derived from the positions of other investors. Chapter 11 discusses an approach called risk parity, which dispenses with expected returns and allocates capital based solely on risk and correlations. In that chapter, we’ll show how, under certain assumptions, risk parity and the canonical mean-variance optimization yield the same optimal portfolio.