# Optimization Quz

For Mean Variance approach, which input is the most important: A) Variance B) Covariance C) Required Return D) Time period - Bonus points for saying HOW MUCH more important they are.

B Covariance explains the relationship between two variables. From this, you can derive correlation.

C- Required Returns.

C

C FTW!

Return and covariance (provides correlation) – both return and correlation define variance so order 1. Return 2. covariance 3. variance 4. time period --> since a change in regime could cause issues for the MV.

C. If you have returns you can calc the other two variables

its most senstivie to returns imputs which is why BL that uses the world portfolio as a starting point is an improvemt

Answer = C : Return is the most important Specifically, Return is 10x more important than variance and 20x more important than covariance (bonus points) Time period is not an input that was specified in the CFAI notes. Curve ball!

A limitation of the mean–variance approach is that its recommended asset allo- cations are highly sensitive to small changes in inputs and, therefore, to estima- tion error. In its impact on the results of a mean–variance approach to asset allocation, estimation error in expected returns has been estimated to be roughly 10 times as important as estimation error in variances and 20 times as important as estimation error in covariances.34 Best and Grauer (1991) demon- strate that a small increase in the expected return of one of the portfolio’s assets can force half of the assets from the portfolio. Thus the most important inputs in mean–variance optimization are the expected returns. Unfortunately, mean returns are also the most difficult input to estimate. (Level III Volume 3 Capital Market Expectations, Market Valuation, and Asset Allocation, 4th Edition. Pearson Learning Solutions 256). Yeah it is C. Fuck, I’m gonna fail.

bpdulog your my benchmark on this forum (Paraguay is way outta my league). If you fail, I fail so don’t say that!

BP, you will pass. It has been written.

Will we get bonus points on test day if we tell CFAI how great and inspiring they are? Might try and work that into each essay response…

Tried that last year. No go. lol.

It should be “expected return”, not “required return” to be specific.

expected returns shuns

bpdulog Wrote: ------------------------------------------------------- > A limitation of the mean–variance approach is that > its recommended asset allo- cations are highly > sensitive to small changes in inputs and, > therefore, to estima- tion error. In its impact on > the results of a mean–variance approach to asset > allocation, estimation error in expected returns > has been estimated to be roughly 10 times as > important as estimation error in variances and 20 > times as important as estimation error in > covariances.34 Best and Grauer (1991) demon- > strate that a small increase in the expected > return of one of the portfolio’s assets can force > half of the assets from the portfolio. Thus the > most important inputs in mean–variance > optimization are the expected returns. > Unfortunately, mean returns are also the most > difficult input to estimate. > (Level III Volume 3 Capital Market Expectations, > Market Valuation, and Asset Allocation, 4th > Edition. Pearson Learning Solutions 256). > > > Yeah it is C. Fuck, I’m gonna fail. No. you aren’t. btw, who do we have a - in demon-strate?

bpdulog Wrote: ------------------------------------------------------- > A limitation of the mean–variance approach is that > its recommended asset allo- cations are highly > sensitive to small changes in inputs and, > therefore, to estima- tion error. In its impact on > the results of a mean–variance approach to asset > allocation, estimation error in expected returns > has been estimated to be roughly 10 times as > important as estimation error in variances and 20 > times as important as estimation error in > covariances.34 Best and Grauer (1991) demon- > strate that a small increase in the expected > return of one of the portfolio’s assets can force > half of the assets from the portfolio. Thus the > most important inputs in mean–variance > optimization are the expected returns. > Unfortunately, mean returns are also the most > difficult input to estimate. > (Level III Volume 3 Capital Market Expectations, > Market Valuation, and Asset Allocation, 4th > Edition. Pearson Learning Solutions 256). > > > Yeah it is C. Fuck, I’m gonna fail. BP, you will pass! We will vote for you!

On seeing this, I highly recommend the Schweser – it helps you get over the finer points for the PM exam I recall this being tested and am happy I remembered it too!