The diversified efficient frontier

The diversified efficient frontier

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Speaker(s): Thomas Heinze (Provinzial Rheinland)

Given Markowitz's mean-risk model, maximization of diversification is established as an additional investment target next to return maximization and risk minimization. This widens the opportunity to transfer market views into the model by additional diversification parameters and should therefore lead to an improved mapping of economic reality. The main focus is on the introduction of diversification functions which make diversification quantifiable and which are used as third objective in the optimization. Thus, the resulting efficient frontier extends to a three dimensional surface which includes the original efficient frontier according to Markowitz. In the end, a model is developed that is as easy to apply as the traditional Markowitz model with the additional input of a diversification target.

In practical applications of the Markowitz model, one often can observe that the computed optimal portfolios are rejected by the investors, although the return forecast and the risk parameters which are used in the model are approved beforehand. The disapproval originates mostly from the extreme structure of the portfolios which, on the one hand, strongly overweights certain investments and excludes others, on the other hand. A diversification target creates some basic structure in the portfolio. Therefore, an implicit market opinion can be addressed beside return- and risk parameters.

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