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Mean-variance optimisation

Solving for the weights that maximise expected return for a given variance, given inputs for expected returns, volatilities and correlations.

MVO is the engine behind the efficient-frontier. Feed it expectations and it returns precise weights. The precision is the trap: the output is extremely sensitive to the expected-return inputs, which are the hardest quantity in finance to estimate.

A worked illustration: raise one asset's assumed return from 6.0% to 7.0% and an unconstrained optimiser may move its weight from 15% to 60%, funded by shorting another holding. Nothing about the world changed, only a guess.

Practitioners tame this with constraints (no shorting, maximum weight per asset), shrinkage of the covariance estimate, resampling across many simulated inputs, or the Black-Litterman approach of starting from market weights and tilting only where a view is strong. See naive-diversification for the humble alternative.

Related: efficient-frontier, modern-portfolio-theory, naive-diversification, equal-risk-contribution, monte-carlo-simulation

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