Mean-Variance Asset Allocation for Individual Investors
May 12, 2016 - Individual Investing, Strategic Allocation
Can individual investors practically implement mean-variance optimization in a multi-asset class context? In their April 2016 paper entitled “Asset Allocation: A Recommendation for Resolving the Collision between Theory and Practice”, Larry Prather, James McCown and Ron Shaw describe how individual investors can construct and maintain a low-cost optimal (maximum Sharpe ratio) multi-class portfolio via the Excel Solver function. They consider four criteria in selecting asset class proxies: (1) market capitalization-weighted coverage of a wide variety of investable assets; (2) small initial investment; (3) low annual expenses; and, (4) versions that investors can short. Based on these criteria, they select five Vanguard index mutual funds and three precious metals:
- Vanguard Total Stock Market Index Fund Investor Shares (VTSMX), capturing the U.S. equity market.
- Vanguard Total International Stock Index Fund Investor Shares (VGTSX), representing 98% of the capitalization of non-U.S. equity markets.
- Vanguard Emerging Markets Stock Index Fund Investor Shares (VEIEX), supplementing VGTSX to better capture emerging market equities.
- Vanguard Total Bond Market Index Fund Investor Shares (VBMFX), providing broad exposure to U.S. investment grade bonds.
- Vanguard REIT Index Fund Investor Shares (VGSIX), providing broad exposure to U.S. Real Estate Investment Trusts (REIT).
- Spot gold, platinum and palladium, offering safe haven and currency exchange rate protection.
These mutual funds and metals have exchange-traded fund (ETF) analogs, supporting optimization with short selling. They assume a constant risk-free rate of 3%. Using daily mutual fund returns and spot metals prices during September 1998 through June 2015, they find that: Keep Reading