Risk-minimising investment strategies — Embedding portfolio optimisation into a dynamic insurance framework

Abstract

While Markowitz's framework of portfolio optimisation aims to eliminate diversifiable risk, it does not consider protection against the undiversifiable, systematic risk of market downturns. This paper investigates a concept of risk-minimising investment strategies, which embeds revolving portfolio optimisations into a framework of dynamic portfolio insurance and thus links the two approaches of minimising the diversifiable and controlling the undiversifiable risk. Investment strategies are generated which minimise the diversifiable risk by revolving optimisations based on newer downside risk measures, value-at-risk and conditional value-at-risk. Portfolio insurance is applied on the investment strategies, in order to control the systematic risk over time. The concept is illustrated by a simplified application example based on historical data, which comprise the most recent period of the financial crisis. The example demonstrates that the performance of investment strategies is stabilised by the application of portfolio optimisation. The choice of risk measure turns out to be of minor relevance. In the period of market decline the impacts of portfolio insurance overlay the impacts of portfolio optimisation. The observations of the case study give reason to suggest that in times of financial instabilities portfolios primarily should be protected against downside risk by adequate portfolio insurance.