Today it is widely recognized that a strategic asset allocation is the single most important decision a long-term investor makes. The dominant quantitative approach is based on Harry Markowitz's mean-variance optimization (MVO) technique. Common sense calls for diversification in a portfolio. But in practice, MVO can lead to highly concentrated allocations to just a few asset classes. The natural errors that occur when applying returns estimates from the past-capital market assumptions-in a forward-looking context are magnified by traditional MVO. Add this to the technique's sensitivity to small changes in input and you have an "estimation error maximizer." These flaws lead some practitioners to set strict asset class constraints, or even abandon MVO altogether.
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