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The New Wealth Management: The Financial Advisor's Guide to Managing and Investing Client Assets by Harold Evensky, Stephen M. Horan, Thomas R. Robinson, Roger Ibbotson

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CHAPTER 10

PORTFOLIO OPTIMIZATION

Any security-specific selection decision is preceded either implicitly or explicitly by an asset allocation decision.

—Scott Lummer and Mark Riepe

Chapter 9, “Asset Allocation,” considered a number of strategies that a wealth manager might use to develop an asset allocation model. We believe that an appropriate strategy is the thoughtful and knowledgeable use of mathematical optimizers.

We recognize and agree with much of the criticism directed at the black boxes. The software available for wealth managers generates projections 5, 10, or even 20 years into the future, carried to the fifth decimal place, with probability measures to the tenth decimal place. This illusion of precision is clearly ludicrous. Any wealth manager who unquestioningly accepts the allocations recommended by an optimizer is likely to be a threat to clients’ financial well-being.

The solution, however, is not to default to an inferior strategy, but rather to recognize that good optimization is a blend of art and science. By “art,” we mean the wealth manager’s use of professional judgment, common sense, and intuition. Integrating complexities, such as parametric quadratic programming with the uncertainties of future events, is not an exercise in pure science. In fact, art, not science, may be the predominant factor. However, acknowledging this reality does not excuse a slipshod understanding of the academic and technical aspects of optimization. Instead, it demands a solid ...

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