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Portfolio Optimization Help Topics: Setting Up the Inputs Running the Optimization Process Analyzing and Utilizing the Results Applications to Business Portfolios
The Portfolio Optimization model is based on the Markowitz portfolio theory developed in the 1950s. This theory is based on the efficient market hypothesis where the optimal portfolio can be found graphically as a tangent to the risk free interest rate. Given the correlation of historical product returns, the efficient frontier of product weightings is then generated to find the combinations with the maximum and minimum return and risk (risk is a function of the products' historical volatilities). This combination is determined by finding the optimal Sharpe (or Sortino) Ratio which is equal to the portfolio's return less the risk-free rate calculated and then divided by the standard deviation of returns.
The model offers additional options to facilitate analysis, modify the assumptions and perform technical analysis on individual investments and the portfolio as a whole. The model is also designed to be applied to either financial instrument or business portfolios. The ability to apply optimization analysis to a portfolio of businesses represents a logical framework for driving capital allocation, and investment or divestment decisions at a corporate level.