Financial Analysts Journal March/April 2010 Volume 66 Issue 2
In Defense of Optimization: The Fallacy of 1/N
Previous research has shown that equally weighted portfolios outperform optimized portfolios, which suggests that optimization adds no value in the absence of informed inputs. This article argues the opposite. With naive inputs, optimized portfolios usually outperform equally weighted portfolios. The ostensible superiority of the 1/N approach arises not from limitations in optimization but, rather, from reliance on rolling short-term samples for estimating expected returns. This approach often yields implausible expectations. By relying on longer-term samples for estimating expected returns or even naively contrived yet plausible assumptions, optimized portfolios outperform equally weighted portfolios out of sample.
About the Author(s)
Mark Kritzman, CFA, is a founding partner and CEO of Windham Capital Management, Boston, Massachusetts.
Sébastien Page, CFA, is head of the Global Multi-Asset Division at T. Rowe Price. He oversees a team of investment professionals dedicated to actively managing a broad set of multi-asset portfolios, including the firm’s target-date franchise. Mr. Page is a member of the Asset Allocation Committee and the Management Committee of T. Rowe Price Group, Inc. Previously, he served as executive vice president at PIMCO, where he led a team focused on research and development of multi-asset solutions. Mr. Page has also served as a senior managing director at State Street Global Markets. He has coauthored three award-winning research papers for the Journal of Portfolio Management and two award-winning papers for the Financial Analysts Journal. Mr. Page is the author of Beyond Diversification: What Every Investor Needs to Know about Asset Allocation and coauthor of Factor Investing and Asset Allocation. He is a member of the Research Committee of the Institute for Quantitative Research in Finance (Q Group) and regularly appears in the financial media, including Bloomberg TV and CNBC. Mr. Page earned a bachelor’s degree in business administration and a master of science degree in finance from the Université de Sherbrooke.
David Turkington, CFA, is senior managing director at State Street Associates, Cambridge, Massachusetts.