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Select and defend an asset allocation using the results of mean–variance optimisation

CFA® Level III · Asset Allocation · Principles of Asset Allocation · L3.AA.4.b

The idea

Screen efficient mixes against constraints, then rank the survivors. Utility is U = E(R) − 0.005 × λ × σ²; with λ = 4, a mix with 7% expected return and 12% volatility scores 7 − 0.005 × 4 × 144 = 4.12, while one with 9% and 18% scores 9 − 6.48 = 2.52, so the lower-risk mix is preferred. If the investor has a minimum return threshold, Roy's safety-first ratio (E(R) − RL) ÷ σ picks the mix with the lowest shortfall probability if returns are roughly normal: with RL = 2%, the ratios are (7 − 2) ÷ 12 = 0.42 and (9 − 2) ÷ 18 = 0.39, so the lower-risk mix wins again. A good justification also checks liquidity and concentration. The trap is picking the highest expected return that meets the target without testing the risk constraint.

Formulas

Roy's safety-first ratio

SFRatio = (E(R) − RL) ÷ σ

E(R)
the mix's expected return
RL
the minimum acceptable return
σ
the mix's standard deviation

Choose the mix with the highest ratio: with roughly normal returns it has the lowest chance of falling below RL. Use it when the client states risk as a return it must not fall below, rather than as volatility.

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