# Portfolio Optimization

**Originally Contributed by**: Arpit Bhatia

Optimization models play an increasingly important role in financial decisions. Many computational finance problems can be solved efficiently using modern optimization techniques.

This tutorial solves the famous Markowitz Portfolio Optimization problem with data from lecture notes from a course taught at Georgia Tech by Shabir Ahmed.

This tutorial uses the following packages

```
using JuMP
import Ipopt
import Statistics
```

Suppose we are considering investing 1000 dollars in three non-dividend paying stocks, IBM (IBM), Walmart (WMT), and Southern Electric (SEHI), for a one-month period.

This means we will use the money to buy shares of the three stocks at the current market prices, hold these for one month, and sell the shares off at the prevailing market prices at the end of the month.

As a rational investor, we hope to make some profit out of this endeavor, i.e., the return on our investment should be positive.

Suppose we bought a stock at $p$ dollars per share in the beginning of the month, and sold it off at $s$ dollars per share at the end of the month. Then the one-month return on a share of the stock is $ \frac{s-p}{p} $.

Since the stock prices are quite uncertain, so is the end-of-month return on our investment. Our goal is to invest in such a way that the expected end-of-month return is at least $50 or 5%. Furthermore, we want to make sure that the “risk” of not achieving our desired return is minimum.

Note that we are solving the problem under the following assumptions:

- We can trade any continuum of shares.
- No short-selling is allowed.
- There are no transaction costs.

We model this problem by taking decision variables $x_{i}, i=1,2,3,$ denoting the dollars invested in each of the 3 stocks.

Let us denote by $\tilde{r}_{i}$ the random variable corresponding to the monthly return (increase in the stock price) per dollar for stock $i$.

Then, the return (or profit) on $x_{i}$ dollars invested in stock $i$ is $\tilde{r}_{i} x_{i},$ and the total (random) return on our investment is $\sum_{i=1}^{3} \tilde{r}_{i} x_{i}.$ The expected return on our investment is then $\mathbb{E}\left[\sum_{i=1}^{3} \tilde{r}_{i} x_{i}\right]=\sum_{i=1}^{3} \overline{r}_{i} x_{i},$ where $\overline{r}_{i}$ is the expected value of the $\tilde{r}_{i}.$

Now we need to quantify the notion of “risk” in our investment.

Markowitz, in his Nobel prize winning work, showed that a rational investor’s notion of minimizing risk can be closely approximated by minimizing the variance of the return of the investment portfolio. This variance is given by:

\[\operatorname{Var}\left[\sum_{i=1}^{3} \tilde{r}_{i} x_{i}\right] = \sum_{i=1}^{3} \sum_{j=1}^{3} x_{i} x_{j} \sigma_{i j}\]

where $\sigma_{i j}$ is the covariance of the return of stock $i$ with stock $j$.

Note that the right hand side of the equation is the most reduced form of the expression and we have not shown the intermediate steps involved in getting to this form. We can also write this equation as:

\[\operatorname{Var}\left[\sum_{i=1}^{3} \tilde{r}_{i} x_{i}\right] =x^{T} Q x\]

Where $Q$ is the covariance matrix for the random vector $\tilde{r}$.

Finally, we can write the model as:

\[\begin{aligned} \min x^{T} Q x \\ \text { s.t. } \sum_{i=1}^{3} x_{i} \leq 1000.00 \\ \overline{r}^{T} x \geq 50.00 \\ x \geq 0 \end{aligned}\]

After that long discussion, lets now use JuMP to solve the portfolio optimization problem for the data given below.

Month | IBM | WMT | SEHI |
---|---|---|---|

November-00 | 93.043 | 51.826 | 1.063 |

December-00 | 84.585 | 52.823 | 0.938 |

January-01 | 111.453 | 56.477 | 1.000 |

February-01 | 99.525 | 49.805 | 0.938 |

March-01 | 95.819 | 50.287 | 1.438 |

April-01 | 114.708 | 51.521 | 1.700 |

May-01 | 111.515 | 51.531 | 2.540 |

June-01 | 113.211 | 48.664 | 2.390 |

July-01 | 104.942 | 55.744 | 3.120 |

August-01 | 99.827 | 47.916 | 2.980 |

September-01 | 91.607 | 49.438 | 1.900 |

October-01 | 107.937 | 51.336 | 1.750 |

November-01 | 115.590 | 55.081 | 1.800 |

```
stock_data = [
93.043 51.826 1.063;
84.585 52.823 0.938;
111.453 56.477 1.000;
99.525 49.805 0.938;
95.819 50.287 1.438;
114.708 51.521 1.700;
111.515 51.531 2.540;
113.211 48.664 2.390;
104.942 55.744 3.120;
99.827 47.916 2.980;
91.607 49.438 1.900;
107.937 51.336 1.750;
115.590 55.081 1.800;
]
```

13×3 Array{Float64,2}: 93.043 51.826 1.063 84.585 52.823 0.938 111.453 56.477 1.0 99.525 49.805 0.938 95.819 50.287 1.438 114.708 51.521 1.7 111.515 51.531 2.54 113.211 48.664 2.39 104.942 55.744 3.12 99.827 47.916 2.98 91.607 49.438 1.9 107.937 51.336 1.75 115.59 55.081 1.8

Calculating stock returns

```
stock_returns = Array{Float64}(undef, 12, 3)
for i in 1:12
stock_returns[i, :] = (stock_data[i + 1, :] .- stock_data[i, :]) ./ stock_data[i, :]
end
stock_returns
```

12×3 Array{Float64,2}: -0.0909042 0.0192374 -0.117592 0.317645 0.0691744 0.0660981 -0.107023 -0.118137 -0.062 -0.0372369 0.00967774 0.533049 0.197132 0.0245391 0.182197 -0.0278359 0.000194096 0.494118 0.0152087 -0.0556364 -0.0590551 -0.0730406 0.145487 0.305439 -0.0487412 -0.140428 -0.0448718 -0.0823425 0.0317639 -0.362416 0.178261 0.0383915 -0.0789474 0.0709025 0.0729508 0.0285714

Calculating the expected value of monthly return:

`r = Statistics.mean(stock_returns, dims = 1)`

1×3 Array{Float64,2}: 0.0260022 0.00810132 0.0737159

Calculating the covariance matrix Q

`Q = Statistics.cov(stock_returns)`

3×3 Array{Float64,2}: 0.018641 0.00359853 0.00130976 0.00359853 0.00643694 0.00488727 0.00130976 0.00488727 0.0686828

JuMP Model

```
portfolio = Model(Ipopt.Optimizer)
set_silent(portfolio)
@variable(portfolio, x[1:3] >= 0)
@objective(portfolio, Min, x' * Q * x)
@constraint(portfolio, sum(x) <= 1000)
@constraint(portfolio, sum(r[i] * x[i] for i = 1:3) >= 50)
optimize!(portfolio)
objective_value(portfolio)
```

22634.417849884154

`value.(x)`

3-element Array{Float64,1}: 497.04552984986384 0.0 502.9544801594811

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