UV2558

August 25, 2009

VIRGINIA INVESTMENT PARTNERS OPTIMAL PORTFOLIO ALLOCATION

Gazing out your office window at the Blue Ridge Mountains, you ponder how to proceed
with your first client. You have recently joined Virginia Investment Partners (VIP) in
Charlottesville, VA, and your first assignment is to suggest an investment plan for a prospective
client. The client is an IBM executive whose portfolio consists entirely of his company’s stock.
VIP typically suggests an overall investment plan that allocates the client’s assets across three
broad classes: U.S. domestic equity as proxied by the S&P 500 Index, U.S. fixed income as
proxied by the Lehman Brothers Aggregate Bond Index, and foreign equity as proxied by the
MSCI World Index (excluding the United States). To prepare the investment plan, you have
access to 10 years of monthly return data for three asset classes and IBM 1 (Exhibit 1) as well as
the company’s proprietary mean-variance optimizer (Exhibit 2).

1. Using the return data for IBM in Exhibit 1, calculate the mean and standard deviation for
the stock.
2. Assume a portfolio with three equally weighted asset classes. Using the return data in
Exhibit 1, calculate the monthly return for this portfolio from January 1997 to December
2006. The formula for this return will simply be the weighted average return (i.e., R Portfolio
= WeightSP500*RSP500 + WeightMSCI*RMSCI + WeightLehmanAgg*RLehmanAgg). From these
returns, calculate the mean and standard deviation of the portfolio. What arguments could
be made for the client to sell IBM and diversify into such a portfolio? What arguments
could be made against it?
3. Using the mean-variance optimizer in Exhibit 2, calculate the weights in the three asset
classes (Domestic Equity as proxied by the S&P 500, International Equity as proxied by
the MSCI World Index, and U.S. Fixed Income as proxied by the Lehman Brothers
Aggregate Bond Index) for the optimal portfolio when the target standard deviation is
10%. In this exercise, the optimal portfolio is the portfolio with the maximum return for a
given level of risk as proxied by the standard deviation. To calculate the weights for this
optimal portfolio, follow the instructions in the Appendix on enabling and using Solver.
Once you have the Solver dialog box on the screen, you need to identify the following:

1
The return calculated is a holding-period return where all dividends and distributions are assumed to be
reinvested at NAV.

The structured exercise in this technical note was prepared by Richard B. Evans, Assistant Professor of Business
Administration. Copyright  2009 by the University of Virginia Darden School Foundation, Charlottesville, VA.
All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this
publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by
any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden
School Foundation.
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a. What is it you want to maximize? For this example, we will optimize the return of the
combined portfolio. To do this, click the Set Target Cell dialog box and then click on
the cell containing the portfolio return. Then, click on the Max option. The optimizer
is now set to find the maximum possible return for the portfolio.
b. What parameters could change in order to maximize the return of the portfolio?
Typically we assume the returns, standard deviations, and correlations of the asset
classes in the optimization are constant and cannot be changed by the investment
advisor. What the advisor has control over is the weight in each of the asset classes.
In order to let the optimizer know what parameters it can change in order to find the
portfolio with the optimal return, click on the By Changing Cells option and then
highlight the three weights.
c. What constraints should be placed on the optimized portfolio? There are two required
constraints on the optimization. First, the weights in the three portfolios should sum
to 100% or equivalently 1.00 if you are using fractional notation. To input this
constraint, click on the Add button next to the Subject to the Constraints dialog box.
Then input the sum of the three weights on the left-hand side and 100% or
equivalently 1.00 on the right-hand side. Be sure to change the ≤ sign to an = sign.
The second constraint is to set the portfolio standard deviation equal to the target
standard deviation. To set this constraint, first type in the desired standard deviation
in the portfolio target standard deviation cell. Then repeat the steps above and set the
portfolio annualized standard deviation equal to the target standard deviation.
Additional constraints on the portfolio weights or on other aspects of the optimization
may also be input.
4. Repeat the exercise in 3 for target standard deviations of 2%, 6%, 14%, and 20%. To do
this, just change the value in the portfolio target standard deviation cell and rerun Solver.
Are all of these feasible portfolios? What additional assets or investment strategies would
you need to reach these targets on the investment frontier? What impact would including
these additional assets or investment strategies have the risk and return of the portfolio?
Do these portfolios suggest additional constraints that should be placed on the
optimization?
5. Plot the portfolio return and standard deviation for each of the targets above and compare
this graphically to the mean and standard deviation of the client’s current portfolio. Is this
a compelling argument for diversification?
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Exhibit 1
VIRGINIA INVESTMENT PARTNERS OPTIMAL PORTFOLIO ALLOCATION
Monthly Return Data
MSCI World Index Lehman Brothers
Date S&P 500 IBM
(excluding U.S.) Aggregate Bond Index
Jan-97 6.25% −3.12% 0.31% 3.55%
Feb-97 0.78% 1.52% 0.25% −8.14%
Mar-97 −4.11% 0.10% −1.11% −4.52%
Apr-97 5.97% 0.61% 1.50% 16.94%
May-97 6.09% 6.59% 0.95% 8.04%
Jun-97 4.48% 5.34% 1.19% 4.34%
Jul-97 7.96% 1.84% 2.70% 17.17%
Aug-97 −5.60% −7.37% −0.85% −3.95%
Sep-97 5.48% 5.61% 1.48% 4.56%
Oct-97 −3.34% −7.54% 1.45% −7.08%
Nov-97 4.63% −1.12% 0.46% 11.37%
Dec-97 1.72% 0.95% 1.01% −4.45%
Jan-98 1.11% 4.26% 1.28% −5.62%
Feb-98 7.21% 6.51% −0.08% 5.96%
Mar-98 5.12% 3.28% 0.34% −0.54%
Apr-98 1.01% 0.78% 0.52% 11.55%
May-98 −1.72% −0.52% 0.95% 1.59%
Jun-98 4.06% 0.53% 0.85% −2.29%
Jul-98 −1.06% 0.65% 0.21% 15.41%
Aug-98 -14.46% −12.77% 1.63% −14.83%
Sep-98 6.41% −2.86% 2.34% 14.10%
Oct-98 8.13% 10.41% −0.53% 15.56%
Nov-98 6.06% 5.07% 0.57% 11.34%
Dec-98 5.76% 3.84% 0.30% 11.66%
Jan-99 4.18% 0.02% 0.71% −0.61%
Feb-99 −3.11% −2.52% −1.74% −7.25%
Mar-99 4.00% 4.17% 0.55% 4.42%
Apr-99 3.87% 4.29% 0.32% 18.02%
May-99 −2.36% −5.05% −0.87% 11.02%
Jun-99 5.55% 3.91% −0.31% 11.42%
Jul-99 −3.12% 2.88% −0.42% −2.76%
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Exhibit 1 (continued)

MSCI World Index Lehman Brothers

Date S&P 500 IBM
(excluding U.S.) Aggregate Bond Index
Aug-99 −0.49% 0.28% −0.05% −0.80%
Sep-99 −2.74% 1.08% 1.16% −2.86%
Oct-99 6.33% 3.86% 0.37% −18.80%
Nov-99 2.03% 3.50% 0.00% 5.02%
Dec-99 5.89% 9.19% -0.48% 4.67%
Jan-00 −5.02% −6.07% -0.33% 4.06%
Feb-00 −1.89% 2.83% 1.21% −8.36%
Mar-00 9.78% 4.10% 1.32% 14.84%
Apr-00 −3.01% −5.18% −0.29% −5.51%
May-00 −2.05% −2.42% −0.05% −3.58%
Jun-00 2.47% 4.32% 2.08% 2.04%
Jul-00 −1.56% −3.82% 0.91% 2.62%
Aug-00 6.21% 1.31% 1.45% 17.51%
Sep-00 −5.28% −5.18% 0.63% −14.77%
Oct-00 −0.42% −2.72% 0.66% −12.44%
Nov-00 −7.88% −4.02% 1.64% −4.94%
Dec-00 0.49% 3.50% 1.86% −9.09%
Jan-01 3.55% 0.18% 1.64% 31.76%
Feb-01 −9.11% −7.92% 0.87% −10.69%
Mar-01 −6.33% −6.80% 0.50% −3.72%
Apr-01 7.76% 6.97% −0.41% 19.71%
May-01 0.67% −3.28% 0.60% −2.78%
Jun-01 −2.43% −4.10% 0.38% 1.07%
Jul-01 −0.99% −1.72% 2.24% −6.89%
Aug-01 −6.25% −2.67% 1.15% −4.87%
Sep-01 −8.07% −10.09% 1.17% −8.23%
Oct-01 1.91% 2.45% 2.09% 17.83%
Nov-01 7.67% 3.93% −1.37% 7.09%
Dec-01 0.88% 0.64% −0.63% 4.65%
Jan-02 −1.45% −5.08% 0.81% −10.81%
Feb-02 −1.92% 0.61% 0.97% −8.93%
Mar-02 3.76% 5.78% −1.66% 5.99%
Apr-02 −6.06% 0.15% 1.94% −19.46%
May-02 −0.73% 1.31% 0.85% −3.77%
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Exhibit 1 (continued)

MSCI World Index Lehman Brothers

Date S&P 500 IBM
(excluding U.S.) Aggregate Bond Index
Jun-02 −7.12% −4.06% 0.87% −10.50%
Jul-02 −7.79% −9.94% 1.21% −2.22%
Aug-02 0.65% −0.15% 1.69% 7.29%
Sep-02 −10.80% −10.60% 1.62% −22.65%
Oct-02 8.79% 5.25% −0.46% 35.38%
Nov-02 5.88% 4.60% −0.03% 10.30%
Dec-02 −5.87% −3.23% 2.07% −10.84%
Jan-03 −2.62% −3.81% 0.09% 0.90%
Feb-03 −1.50% −1.97% 1.38% −0.13%
Mar-03 0.97% −1.93% −0.08% 0.62%
Apr-03 8.24% 9.60% 0.83% 8.25%
May-03 5.27% 6.20% 1.86% 3.89%
Jun-03 1.28% 2.43% −0.20% −6.29%
Jul-03 1.76% 2.29% −3.36% −1.52%
Aug-03 1.95% 2.58% 0.66% 1.13%
Sep-03 −1.06% 3.00% 2.65% 7.71%
Oct-03 5.66% 6.26% −0.93% 1.30%
Nov-03 0.88% 2.27% 0.24% 1.36%
Dec-03 5.24% 7.67% 1.02% 2.36%
Jan-04 1.84% 1.39% 0.80% 7.07%
Feb-04 1.39% 2.30% 1.08% −2.59%
Mar-04 −1.51% 0.50% 0.75% −4.83%
Apr-04 −1.57% −2.62% −2.60% −4.00%
May-04 1.37% 0.30% −0.40% 0.68%
Jun-04 1.94% 2.48% 0.57% −0.50%
Jul-04 −3.31% −3.05% 0.99% −1.23%
Aug-04 0.40% 0.42% 1.91% −2.53%
Sep-04 1.08% 2.91% 0.27% 1.24%
Oct-04 1.53% 3.59% 0.84% 4.68%
Nov-04 4.05% 6.65% −0.80% 5.20%
Dec-04 3.40% 4.22% 0.92% 4.61%
Jan-05 −2.44% −1.97% 0.63% −5.23%
Feb-05 2.10% 4.45% −0.59% −0.71%
Mar-05 −1.77% −2.27% −0.51% −1.30%
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Exhibit 1 (continued)

MSCI World Index Lehman Brothers

Date S&P 500 IBM
(excluding U.S.) Aggregate Bond Index
Apr-05 −1.90% −2.55% 1.35% −16.42%
May-05 3.18% 0.18% 1.08% −0.82%
Jun-05 0.14% 1.63% 0.55% −1.79%
Jul-05 3.72% 3.23% −0.91% 12.48%
Aug-05 −0.91% 2.76% 1.28% −3.16%
Sep-05 0.81% 4.56% −1.03% −0.50%
Oct-05 −1.67% −3.23% −0.79% 2.07%
Nov-05 3.78% 2.65% 0.44% 8.82%
Dec-05 0.04% 4.64% 0.95% −7.54%
Jan-06 2.65% 6.33% 0.01% −1.09%
Feb-06 0.27% −0.34% 0.33% −1.06%
Mar-06 1.24% 3.17% −0.98% 2.78%
Apr-06 1.34% 4.78% −0.18% −0.16%
May-06 −2.88% −3.80% −0.11% −2.60%
Jun-06 0.14% −0.13% 0.21% −3.85%
Jul-06 0.62% 0.94% 1.35% 0.77%
Aug-06 2.38% 2.84% 1.53% 4.99%
Sep-06 2.58% −0.08% 0.88% 1.20%
Oct-06 3.26% 3.95% 0.66% 12.68%
Nov-06 1.90% 2.98% 1.16% −0.12%
Dec-06 1.40% 2.87% −0.58% 5.69%
Data source: Yahoo! Finance and Morningstar.
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Exhibit 2
VIRGINIA INVESTMENT PARTNERS OPTIMAL PORTFOLIO ALLOCATION
Mean-Variance Optimizer

S&P 500 MSCI World Lehman Brothers Combined Portfolio

Index (excluding Aggregate Bond Return
the United States) Index SP500/MSCI/Lehman
Bond
Weight 100.00% 0.00% 0.00% 100.00%
Annualized average 9.30% 8.84% 6.14% 9.30%
return
Annualized standard 15.34% 15.11% 3.56% 15.34%
deviation
Portfolio target 10.00%
standard deviation
Sharpe ratio (assuming 0.61 0.58 1.72 0.61
risk free = 3%)

Correlation Matrix S&P 500 MSCI World Lehman Brothers

Index (excluding Aggregate Bond
the United States) Index
S&P 500 1.00 0.80 −0.10
MSCI World Index 1.00 −0.14
(excluding the United
States)
Lehman Brothers −0.10 −0.14 1.00
Aggregate Bond Index
Data source: Yahoo! Finance and Morningstar.
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Appendix
VIRGINIA INVESTMENT PARTNERS OPTIMAL PORTFOLIO ALLOCATION
Excel 2007 Solver

Excel comes equipped with an optimizer called Solver. Solver can be used to maximize or
minimize any function of your choice, subject to certain constraints. To use Excel Solver you
must first enable the Solver Add-In. If you have not done this before, the instructions below will
walk you through the steps required to enable the Add-In.

1. Click on the Office button in the upper left-hand corner of the Excel screen. By clicking
on this button, the standard menu of saving, printing, and publishing options appears (see
image below). At the bottom of this menu in the center is the Excel Options button. Click
on this button.

2. After you click on the Excel Options, a new screen will open. In the left-hand column,
find the Add-Ins option and click on it.
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Appendix (continued)

3. At the bottom of the Add-Ins screen is the Manage: Excel Add-Ins option (see picture
above). Click on the Go button to the left of this option, which will take you to a list of all
the available Add-Ins. On this list (see picture below), click the box next to Solver.

4. The Solver Add-In is now active. To access the Solver, click on the Data tab at the top of
the Excel Window. The Solver option is at the far right of the top menu.

5. When you click on the Solver Add-In, the dialog box below will appear. While the dialog
box has many options, the following are the three important components for the
optimization:
a. The cell/function to minimize/maximize (Set Target Cell)
b. The cells/parameters that can be changed in order to minimize or maximize the
function of interest (By Changing Cells)
c. The set of constraints imposed upon the optimization (Subject to the Constraints)
After identifying these options, you can then click on the Solve button, and Solver will
output the optimal parameters of interest (in our case portfolio weights) associated with
the maximized/minimized function of interest.