Portfolio Optimization, Heuristics, and the "Butterfly Effect"

The same effect is at work with portfolio optimizers that perform asset allocation and portfolio allocation chores. A small change to an input works its way through the system of equations and results in a large change in allocations. As a result, it is very easy to arrive at a set of "non-intuitive" allocations; i.e. they don't exhibit common sense. Once a set of portfolio allocations is put into place, a small change in the market will result in large changes (sometimes negative) in the portfolio returns. Practitioners, understandingly, have been losing confidence in the results of portfolio optimizers. The purpose of this paper is to explore the reasons why and to offer one reasonable alternative, a portfolio heuristic.