Portfolio Allocation Model

Author
Decisioneering, Inc.

Summary
An investor has $100,000 to invest in four assets. The source of uncertainty in this problem is the annual return of each
asset. The more conservative assets have relatively stable annual returns, while the least conservative asset has higher
volatility. The decision problem is to determine how much to invest in each asset to maximize the total expected annual
return while maintaining the risk at an acceptable level and keeping within the minimum and maximum limits for each
investment.

Note: This example is presented as the second tutorial in the Getting Started chapter in the OptQuest User Manual.The
tutorial provides more details than this description. Make sure not to confuse this example with the other portfolio
examples.

Keywords: portfolio allocation, assets, constraint, volatility, optimization, correlation matrix

Discussion
Below is a list of the assets’ expected annual returns and the minimum and maximum amounts the investor is
comfortable allocating to each investment.

Annual Lower Upper

Investment return bound bound
Money market fund 3% $0 $50,000
Income fund 5% $10,000 $25,000
Using Crystal Ball
Growth and income fund 7% $0 $80,000
Crystal Ball enhances your Excel model by letting you create probability distributions that describe the uncertainty
Aggressive growth fund 11% $10,000 $100,000
surrounding specific input variables. This model includes four probability distributions, referred to in Crystal Ball as
"assumptions." These assumptions describe the uncertainty surrounding each of the investment Annual returns. Each
assumption cell is colored green and is marked by an Excel note (mouse over the cell to view the note). To view the
details of an assumption, highlight the cell and either select Define Assumption from the Define menu or click on the
Define Assumption button on the Crystal Ball toolbar.

This model also includes one Crystal Ball forecast, shown in light blue. Forecasts are equations, or outputs, that you
want to analyze after a simulation. During a simulation, Crystal Ball saves the values in the forecast cells and displays
them in a Forecast Chart, which is a histogram of the simulated values. In this example, you want to analyze the Total
expected return of the portfolio. To view a forecast with Crystal Ball, highlight the cell and either select Define Forecast
from the Define menu or click on the Define Forecast button on the toolbar.

Using Crystal Ball, cont.

When you run a simulation, Crystal Ball generates a random number for each assumption (based on how the
assumption has been defined) and places that new value in the cell. Excel then recalculates the model. You can test
this by selecting Single Step from the Run menu or clicking on the Single Step button on the toolbar.

After you run a simulation, you will see the Total Expected Return forecast chart. What is the certainty that you will see
a return of $6,500 (your original forecast)? How likely are you to lose money on your portfolio?
Using Crystal Ball, cont.
When you run a simulation, Crystal Ball generates a random number for each assumption (based on how the
assumption has been defined) and places that new value in the cell. Excel then recalculates the model. You can test
this by selecting Single Step from the Run menu or clicking on the Single Step button on the toolbar.

After you run a simulation, you will see the Total Expected Return forecast chart. What is the certainty that you will see
a return of $6,500 (your original forecast)? How likely are you to lose money on your portfolio?

To view which of the assumptions had the greatest impact on the forecast, use the Sensitivity Chart. Which of the
annual returns causes the most variation in the Total Expected Return forecast? Was this obvious from the assumption
definitions?

Using OptQuest
Now that you have run at least one simulation, you can begin to address optimization using OptQuest. So far, you
have run simulations where you invested an equal amount in each fund. If you want to change the invested amounts,
you can switch them and run a new simulation. With more than two funds, however, this quickly becomes tedious. With
OptQuest, you can run through hundreds of strategies in far less time. In this model, you will use OptQuest to
determine how much to invest in each asset to maximize the total expected annual return while maintaining the risk at
an acceptable level and keeping within the minimum and maximum limits for each investment.

OptQuest requires decision variables, which are model variables over which you have control. In this model, you will
need to first define these decisions, which are the four investment amounts for the funds. To define a decision variable,
either select Define Decision from the Define menu or click on the Define Decision button on the Crystal Ball toolbar.
Use the amounts listed in the table in the Discussion section above, and set the Variable Type to Continuous. Once
defined, each decision variable is colored yellow and is marked by an Excel note (mouse over the cell to view the
note).

Start OptQuest from the CBTools menu. Once in OptQuest, use the File > Open option to open the Portfolio
Allocation.opt settings file in the Examples > OptQuest Files folder. Use the OptQuest Wizard, either from the toolbar
or from the Tools menu, to view the settings for the optimization. The problem has one constraint, one requirement,
and one objective: to maximize the mean Total Expected Return forecast. The constraint in this problem is your
budget, which is a maximum investment of $100,000. You do not want to optimize portfolios with budgets larger than
this amount, so you need to define a linear constraint that is as follows:

Money Market fund + Income fund + Growth and Income fund + Aggressive Growth fund <= 100000

You are also concerned about controlling the variability of the solution to minimize your risk. To
reduce the uncertainty of returns for the portfolio, while still attempting to maximize the expected return, you can set
requirement in the Define Objective window. Using Edit > Duplicate, you can create a second Total Expected Return
forecast as a requirement, where the standard deviation of the forecast must be below $8,000.

Run the optimization. For each optimization, OptQuest selects a new value within the defined range of the decision
variable (for example, $10,000) and runs a Crystal Ball simulation (for example, 2,000 trials). OptQuest then saves the
mean Total Expected Return value and checks to see if the resulting forecast complies with the risk requirement. If the
requirement is satisfied, the result is "feasible" and considered good. OptQuest ignores infeasible results. OptQuest
then runs another simulation on a new set of decision variables. OptQuest repeats this process, constantly searching
for the highest feasible mean Total Expected Return until it either works through every possible solution or reaches the
end of the set running time.
Using OptQuest, cont.
As OptQuest runs, it uses multiple metaheuristic methods and techniques to analyze past results and improve the
quality and speed of its process. You can watch OptQuest's progress through the Performance Graph, which shows a
flattened line as it converges to an optimal result.

What is the best allocation strategy that results in the highest mean total expected return? Once OptQuest is finished,
you can copy the optimal results back to your spreadsheet with the Copy To Excel option in the Edit menu. Your
spreadsheet now displays the optimal solution, and Crystal Ball displays the forecast chart for the simulation from the
best optimization. You can use OptQuest's Solution Analysis tool to review the other portfolio allocations that resulted
in high Total Expected Return values.

The tutorial in the Getting Started chapter in the OptQuest User Manual includes practice exercises for this model
using correlation, precision control, and a varying number of trials.

Using the Correlation Matrix Tool

The Crystal Ball User Manual uses this example to describe the operation of the Correlation Matrix tool, which lets you
define a matrix of correlations between assumptions in one
simple step. This saves time and effort when building your spreadsheet model, especially for models with many
correlated assumptions. To run the tool, select CBTools > Correlation Matrix and follow the two-step process.
Suggested settings:

Step 1 = Include all the assumptions in the correlation matrix by moving all the assumptions from
the Available Assumptions field to the Selected Assumptions field
Step 2 = Location Of Matrix set to Create A Temporary Correlation Matrix On A New Worksheet,
Orientation set to Upper Triangular Matrix

After Step 2, the tool creates a temporary matrix in a new workbook. You can enter coefficients and click on the Load
The Matrix button to enter them into the defined assumption definitions.

More information on the Correlation Matrix tool is available in the Crystal Ball User Manual and on the Decisioneering
Web site (http://www.crystalball.com).

Additional Resources
If you have Crystal Ball installed, you can run a simulation on this model. If you do not have a copy of Crystal Ball, you
can download a free, seven-day evaluation version from the Decisioneering Web site:

http://www.crystalball.com/downloadform.html

For other model resources and information, visit: http://models.crystalball.com.

Copyright and Contact Information

This spreadsheet model is the property of Decisioneering, Inc. Copyright (c) 2004 Decisioneering, Inc. All Rights
Reserved. Microsoft is a registered trademark of Microsoft Corporation in the U.S. and other countries.

For questions concerning this model or the Crystal Ball software, contact the closest office listed on our Web site
(http://www.crystalball.com) or send an email to sales@crystalball.com. If you have a technical problem with this
model, please contact our support Help Desk: helpdesk@crystalball.com.
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 A B C D E F G
1 Portfolio Allocation Model
2
3 Annual Lower Upper
4 Investments return bound bound
5 Money Market fund 3.0% $0 $50,000
6 Income fund 5.0% $10,000 $25,000
7 Growth and Income fund 7.0% $0 $80,000
8 Aggressive Growth fund 11.0% $10,000 $100,000
9 Total amount available $100,000
10
11 Amount Total amount
Constraint
12 Decision variables invested invested
13 Money Market fund $25,000 $100,000
14 Income fund $25,000
Decision Variables
15 Growth and Income fund $25,000
16 Aggressive Growth fund $25,000
17 Total expected return $6,500
Maximize
18 Objective
19