Enhancing utility and diversifying model risk in a portfolio optimization framework

• US 6,292,787 B1
• Filed: 09/11/1998
• Issued: 09/18/2001
• Est. Priority Date: 09/11/1998
• Status: Expired due to Term

• Current Assignee: Financial Engines, LLC.
• Original Assignee: Financial Engines Incorporated (Edelman Financial Engines LLC)
• Inventors: Jones, Christopher L., Watson, John G., Scott, Jason S., Shearer, James W.
• Primary Examiner(s): Trammell, James P.
• Assistant Examiner(s): Dixon, Thomas A.
• Application Number:
  US09/151,715
• Time in Patent Office: 1,103 Days
• Field of Search: 705/36, 705/35, 705/38, 705/30, 705/37, 707/4, 707/10
• US Class Current: 705/36.00R
• CPC Class Codes: G06Q 40/06 Asset management; Financial planning or analysis

Abstract

A portfolio optimization process that diversifies model risk by favoring a more diversified portfolio over other portfolios with similar characteristics is provided. According to one aspect of the present invention, a more diverse portfolio may be selected over an initial portfolio in order to diversify model risk with reference to a predetermined diversity budget, defined in terms of expected return, risk, and/or utility. An initial portfolio of financial products is determined from an available set of financial products. One or more dimensions of an error space are searched for an alternate portfolio that is more diverse than the initial portfolio. A cost associated with the alternate portfolio is then calculated by comparing the difference between a characteristic of the initial portfolio and a corresponding characteristic of the alternate portfolio. Finally, the alternate portfolio is selected as the recommended portfolio if the cost is less than or equal to the predetermined diversity budget. According to another aspect of the present invention an intelligent search is performed for a diverse portfolio that meets a predetermined diversity budget. An initial portfolio is determined based upon an available set of financial products. The cost associated with more diversified portfolios compared to the initial portfolio is considered and one of the more diversified portfolios is selected that has an associated cost that is less than or equal to the predetermined diversity budget.

Claims

1. A method of diversifying model risk when selecting a portfolio comprising one or more financial products of an available set of financial products, the method comprising the steps of:

determining an initial portfolio of financial products from an available set of financial products;

determining an alternate portfolio that is more diverse than the initial portfolio by searching one or more dimensions of an error space;

calculating a cost associated with the alternate portfolio by comparing the difference between a characteristic of the initial portfolio and a corresponding characteristic of the alternate portfolio; and

selecting the alternate portfolio if the cost is less than or equal to a predetermined diversity budget.

2. The method of claim 1, wherein searching one or more dimensions of an error space comprises evaluating portfolios having substantially the same level of risk as the initial portfolio but having lower expected returns.

3. The method of claim 1, wherein searching one or more dimensions of an error space comprises evaluating portfolios having approximately the same expected returns as the initial portfolio but having a higher level of risk.

4. The method of claim 1, wherein searching one or more dimensions of an error space comprises evaluating portfolios with higher diversity levels, but with utility levels which do not fall below a predetermined utility floor defined by a utility budget.

5. A method of selecting a portfolio comprising one or more financial products of an available set of financial products, the method comprising the steps of:

determining an initial portfolio of financial products from an available set of financial products;

considering the cost associated with a set of more diversified portfolios compared to the initial portfolio; and

selecting a portfolio from the set of more diversified portfolios having an associated cost that is less than or equal to a predetermined diversity budget.

6. The method of claim 5, wherein the step of selecting a portfolio from the set of more diversified portfolios having an associated cost that is less than or equal to a predetermined diversity budget comprises selecting the most diverse portfolio of the set of more diversified portfolios having an associated cost that is less than or equal to the predetermined diversity budget.

7. The method of claim 5, wherein the step of considering the cost associated with a set of more diversified portfolios compared to the initial portfolio comprises the steps of:

(a) generating a more diverse portfolio than the initial portfolio; and

(b) measuring a cost associated with the more diverse portfolio by comparing a first characteristic of the initial portfolio and a corresponding first characteristic of the more diverse portfolio.

8. The method of claim 7, wherein the step of generating a more diverse portfolio than the initial portfolio comprises the steps of:

setting a maximum exposure for any individual financial product of the available set of financial products to a value that is lower than 100%; and

performing a portfolio optimization routine while constraining the holdings in individual financial products of the available set of financial products to the maximum exposure, allowing the first characteristic of the initial portfolio to vary, and holding one or more other characteristics of the initial portfolio constant.

9. The method of claim 8, wherein subsequent more diverse portfolios are iteratively determined by performing the steps of:

modifying the maximum exposure; and

performing steps (a) and (b) until one or more stopping conditions are met.

10. The method of claim 9, wherein the stopping conditions include one or more of the following:

the cost exceeds a predetermined diversity budget;

holding the one or more other characteristics of the initial portfolio constant is no longer feasible;

the maximum exposure is less than a predetermined minimum exposure threshold;

exposure to a predetermined maximum number of financial products has been achieved;

a predetermined number of iterations has been performed; and

a predetermined number of alternate portfolios has been considered.

11. The method of claim 10, wherein the predetermined diversity budget is a user-specified parameter.

12. The method of claim 8, wherein the step of modifying the maximum exposure comprises lowering the maximum exposure each iteration.

13. The method of claim 8, wherein the step of modifying the maximum exposure comprises the steps of:

selecting a new maximum exposure value according to a binary search algorithm; and

setting the maximum exposure to the new maximum exposure value.

14. The method of claim 13, wherein a monotonic relationship is assumed between the cost and the maximum exposure, and wherein the step of selecting a new maximum exposure value is based upon both the binary search algorithm and the monotonic relationship.

15. A method of selecting a portfolio comprising one or more mutual fund products of an available set of mutual fund products, the method comprising the steps of:

determining an initial portfolio and a plurality of more diversified portfolios of mutual fund products from an available set of mutual fund products;

determining a cost associated with each of the plurality of more diversified portfolios; and

selecting a portfolio of the plurality of more diversified portfolios if the cost is less than or equal to a predetermined diversity budget.

16. The method of claim 15, wherein the step of selecting a portfolio of the plurality of more diversified portfolios if the cost is less than or equal to a predetermined diversity budget comprises selecting the most diversified portfolio of the more diversified portfolios having an associated cost that is less than or equal to the predetermined diversity budget.

17. The method of claim 16, wherein the step of generating a more diverse portfolio than the initial portfolio comprises the steps of:

setting a maximum exposure for any individual mutual fund product of the available set of mutual fund products to a value that is lower than 100%; and

performing a portfolio optimization routine while constraining the holdings in individual mutual fund products of the available set of mutual fund products to the maximum exposure, allowing the expected return to vary, and holding a measure of risk associated with the initial portfolio constant.

18. The method of claim 15, wherein the step of determining a cost associated with each of the plurality of more diversified portfolios comprises the steps of:

(a) generating a more diverse portfolio than the initial portfolio; and

(b) measuring a cost associated with the more diverse portfolio by comparing a first expected return associated with the initial portfolio with a second expected return associated with the more diverse portfolio.

19. The method of claim 17, wherein subsequent more diverse portfolios are iteratively determined by performing the steps of:

modifying the maximum exposure; and

performing steps (a) and (b) until one or more stopping conditions are met.

20. The method of claim 19, wherein the stopping conditions include one or more of the following:

the cost exceeds a predetermined diversity budget;

holding the measure of risk constant is no longer feasible;

the maximum exposure is less than a predetermined minimum exposure threshold;

exposure to a predetermined maximum number of mutual fund products has been achieved;

a predetermined maximum number of iterations has been performed; and

a predetermined maximum number of alternate portfolios has been considered.

21. The method of claim 20, wherein the predetermined diversity budget is a user-specified parameter.

22. The method of claim 19, wherein the step of modifying the maximum exposure comprises lowering the maximum exposure each iteration.

23. The method of claim 19, wherein the step of modifying the maximum exposure comprises the steps of:

selecting a new maximum exposure value according to a binary search algorithm; and

setting the maximum exposure to the new maximum exposure value.

24. The method of claim 23, wherein a monotonic relationship is assumed between the cost and the maximum exposure, and wherein the step of selecting a new maximum exposure value is based upon both the binary search algorithm and the monotonic relationship.

25. A method of selecting a portfolio comprising one or more financial products of an available set of financial products, the method comprising the steps of:

determining an initial portfolio of financial products from an available set of financial products;

determining one or more alternate portfolios that are more diverse than the initial portfolio;

measuring a cost associated with achieving diversity by comparing one or more characteristics of the initial portfolio and the one or more alternate portfolios; and

selecting a portfolio of the one or more alternate portfolios if the cost is less than or equal to a predetermined diversity budget.

26. The method of claim 25, wherein the cost is defined in terms of expected return, and wherein the step of measuring a cost associated with achieving diversity comprises determining a difference between an expected return associated with the initial portfolio and expected returns associated with the one or more alternate portfolios.

27. The method of claim 26, wherein the predetermined diversity budget is between approximately 0 to 16 basis points, inclusive.

28. The method of claim 25, wherein the cost is defined in terms of risk, and wherein the step of measuring a cost associated with achieving diversity comprises determining a difference between the risk associated with the initial portfolio and risks associated with the one or more alternate portfolios.

29. The method of claim 28, wherein the predetermined diversity budget comprises an annual standard deviation between approximately 0 and 0.01.

30. The method of claim 25, wherein the cost is defined in terms of a utility, and wherein the step of measuring a cost associated with achieving diversity comprises determining a difference between a first utility associated with the initial portfolio and a second utility associated with the one or more alternate portfolios.

31. The method of claim 30, wherein the predetermined diversity budget is dependent upon a predefined utility function.

32. The method of claim 25, wherein the available set of financial products comprises an arbitrary collection of mutual funds or stocks.

33. The method of claim 25, further comprising the step of performing a portfolio optimization routine that constrains the holdings in individual financial products of the available set of financial products to a maximum exposure and constrains risk to a measure of risk associated with the initial portfolio.

34. A method of selecting a recommended portfolio comprising one or more financial products of an available set of financial products, the method comprising the steps of:

determining a first portfolio having a first expected return and associated with a first level of risk, the first portfolio comprising a utility maximizing combination of financial products from a set of available financial products in which the largest holding is limited to X% of the first portfolio;

determining a more diverse portfolio having a second expected return and associated with the first level of risk, the more diverse portfolio comprising a utility maximizing combination of financial products from the set of available financial products in which the largest financial product holding is limited to Y% of the second portfolio, where Y<

X;

if the difference between the first expected return and the second expected return is less than a diversity budget, then selecting the more diverse portfolio as the recommended portfolio;

otherwise selecting the first portfolio as the recommended portfolio.

35. A method of selecting a portfolio comprising one or more financial products of an available set of financial products, the method comprising the steps of:

determining an initial portfolio and a plurality of more diversified portfolios of financial products from an available set of financial products;

determining a cost associated with each of the plurality of more diversified portfolios; and

selecting the most diversified portfolio of the more diversified portfolios having an associated cost that is less than or equal to a predetermined diversity budget.

36. The method of claim 35, wherein the cost is measured in terms of an expected return, a risk, or a utility.

37. A computer system comprising:

a storage device having stored therein a portfolio optimization routine for simulating portfolio return scenarios for one or more portfolios including combinations of financial products from an available set of financial products;

a processor coupled to the storage device for executing the portfolio optimization routine to select between an initial portfolio and a more diverse portfolio and evaluate a cost associated with implementing the more diverse portfolio rather than the initial portfolio, where;

the initial portfolio is determined with a first maximum exposure constraint;

the more diverse portfolio is determined by imposing a second maximum exposure constraint that limits holdings in any individual financial product of the available set of financial products to a lesser percentage than the first maximum exposure constraint;

the cost reflects the difference between a first expected return associated with the initial portfolio and a second expected return associated with the more diverse portfolio; and

the more diverse portfolio is selected over the initial portfolio if the cost is less than or equal to a predetermined diversity budget.

38. A machine-readable medium having stored thereon data representing sequences of instructions, the sequences of instructions which, when executed by a processor, cause the processor to perform the steps of:

determining an initial portfolio and a plurality of more diversified portfolios of financial products from an available set of financial products;

determining a cost associated with each of the plurality of more diversified portfolios; and

selecting a portfolio of the plurality of more diversified portfolios if the cost is less than or equal to a predetermined diversity budget.

39. The machine-readable medium of claim 38 the sequences of instructions including instructions which, when executed by a processor, further cause the processor to perform the steps of:

selecting a maximum exposure for any individual financial product of the available set of financial products;

generating a more diverse portfolio than the initial portfolio by performing a portfolio optimization routine that constrains the holdings in individual financial products of the available set of financial products to the maximum exposure;

measuring the cost associated with the more diverse portfolio by comparing a characteristic of the initial portfolio and a corresponding characteristic of the more diverse portfolio.

40. A data signal embodied in a propagation medium, the data signal including a plurality of instructions, which when executed by a processor, cause the processor to perform the steps of:

determining an initial portfolio and a plurality of more diversified portfolios of financial products from an available set of financial products;

determining a cost associated with each of the plurality of more diversified portfolios; and

selecting a portfolio of the plurality of more diversified portfolios if the cost is less than or equal to a predetermined diversity budget.

41. The data signal of claim 40 wherein the data signal includes instructions, which when executed by the processor, further cause the processor to perform the steps of:

selecting a maximum exposure for any individual financial product of the available set of financial products;

generating a more diverse portfolio than the initial portfolio by performing a portfolio optimization routine that constrains the holdings in individual financial products of the available set of financial products to the maximum exposure;

measuring the cost associated with the more diverse portfolio by comparing a characteristic of the initial portfolio and a corresponding characteristic of the more diverse portfolio.