Excel 2003 Guide Portfolio Optimisation with Solver James W.

Taylor
This guide involves using Solver to derive optimal portfolios. It consists of 3 parts: 1. Setting up the Excel Model 2. Optimal Portfolio Selection 3. Interpreting the Optimised Solution First, check that the Solver add-in is attached to Excel. From the main Excel menu, select Tools. If Solver is not one of the options in the resulting drop-down menu, you need to attach it to Excel by selecting Add-Ins. from the same drop-down menu. In the Add-Ins dialog box select Solver Add-In. If this is not one of the options in the dialog box, you need to install Solver from your Microsoft Excel installation disc.

Part 1 Setting up the Excel Model

Open the Excel file portf.xls. The file contains the following information regarding three stocks:

Expected return StDev of return Correlations Stock 1 Stock 2 Stock 3

Stock 1 0.14 0.20 Stock 1 1 0.6 0.4

Stock 2 0.11 0.15 Stock 2 0.6 1 0.7

Stock 3 0.10 0.08 Stock 3 0.4 0.7 1

(a) Specify a possible mixture of the three different stocks by typing fractions in cells B16 to D16. For example, put 50% of your money into Stock X and 50% into Stock Y. This would be specified in the spreadsheet by typing 0.50 in B16, 0.50 in C16 and 0 in D16.

(b) In cell E16, sum the fractions by typing: =sum(B16:D16) This will be useful later when we use Solver because we will need to restrict the sum of fractions to be equal to one. (c) The expected return of 3 stocks is given by:
E wx x wy y wz z wx E x wy E y wz E z

In view of this, type the following formula in cell B20: =B16*B5+C16*C5+D16*D5

(d) The variance of 3 stocks is given by: 2 2 2 2 varwx x wy y wz z wx x wy y wz2 z2 2 wx wy x y xy 2 wx wz x z xz 2 wy wz y z yz In view of this, type the following formula in cell B22 for the standard deviation (risk): =SQRT(B16^2*B6^2+C16^2*C6^2+D16^2*D6^2 +2*B16*C16*B6*C6*C9 +2*B16*D16*B6*D6*D9 +2*C16*D16*C6*D6*D10) Check that the values you get for the expected return and standard deviation are the same as those in the diagram.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 A B C Portfolio Optimisation Using Excel's Solver Stock input data Expected return StDev of return Correlations Stock 1 Stock 2 Stock 3 Stock 1 0.14 0.20 Stock 1 1 0.6 0.4 Stock 2 0.11 0.15 Stock 2 0.6 1 0.7 Stock 3 0.10 0.08 Stock 3 0.4 0.7 1 D E

Investment decision Fractions to invest Stock 1 0.50 Stock 2 0.50 Stock 3 0.00 Total 1.00

Portfolio expected return Portfolio stdev

Actual 0.125 0.157

>=

Required 0.120

If you specify different fractions for the 3 stocks, your spreadsheet model will show the expected return and risk associated with a new portfolio. The best portfolios are those with high expected value and low risk (standard deviation). A common approach to portfolio selection is to decide upon a required level of expected return, and then to search for the portfolio of stocks with minimum risk that has at least that level of expected return. For example, you might decide that you require at least 12% expected return. Type 0.12 in cell D20. Change the fractions of the 3 stocks to see if you can find the portfolio with smallest risk that has expected return of at least 0.12. You may find this search for the optimal portfolio a little tedious. A far more efficient approach is to use optimisation software, such as Excels Solver.

Part 2 Optimal Portfolio Selection

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 A B C Portfolio Optimisation Using Excel's Solver Stock input data Expected return StDev of return Correlations Stock 1 Stock 2 Stock 3 Stock 1 0.14 0.20 Stock 1 1 0.6 0.4 Stock 2 0.11 0.15 Stock 2 0.6 1 0.7 Stock 3 0.10 0.08 Stock 3 0.4 0.7 1 D E

Investment decision Fractions to invest Stock 1 0.50 Stock 2 0.50 Stock 3 0.00 Total 1.00

Portfolio expected return Portfolio stdev

Actual 0.125 0.157

>=

Required 0.120

We will use Solver to find the portfolio that minimises risk subject to a required expected return of 0.12. From the Excel menu, select: Tools Solver

(a) In the resulting dialog box: Set Target Cell as B22 (the st.dev.) Select Minimise By Changing Cells B16:D16 (the fractions of the 3 stocks) Dont press Solve yet.

(b) We must constrain the expected return to be at least the required level of 0.12. In the main Solver dialog box, click on Add.

Complete the small dialog box so that the expected return cell, B20, is constrained to be at least the required value in cell D20. Click OK.

We must constrain the fractions to sum to one. In the main Solver dialog box, click on Add.

Complete the small dialog box so that the sum of the fractions, E16, is set equal to one. Click OK.

(c) We also need to indicate to the software that the fractions in cells B16 to D16 must not be negative (we are not allowing the possibility of selling the stock short). In the main Solver dialog box, click on Options. In the Solver Options dialog box, click on the check box for Assume Non-Negative to leave it ticked. Click OK.

(d) In the main Solver dialog box, click on Solve. In the subsequent dialog box, click OK.

Part 3 Interpreting the Optimised Solution

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 A B C Portfolio Optimisation Using Excel's Solver Stock input data Expected return StDev of return Correlations Stock 1 Stock 2 Stock 3 Stock 1 0.14 0.20 Stock 1 1 0.6 0.4 Stock 2 0.11 0.15 Stock 2 0.6 1 0.7 Stock 3 0.10 0.08 Stock 3 0.4 0.7 1 D E

Investment decision Fractions to invest Stock 1 0.50 Stock 2 0.00 Stock 3 0.50 Total 1.00

Portfolio expected return Portfolio stdev

Actual 0.120 0.122

>=

Required 0.120

Cells B16 to D16 should now display the optimal portfolio: To achieve an expected return of at least 12%, with minimum risk, you should invest 50% of your money in Stock X and 50% in Stock Z. The resultant risk for this portfolio is 12.2% as shown in cell B22. Try another value for the required return. For example, type the value 0.112 (11.2%) in cell D20. Run Solver again. The optimal portfolio should appear in cells B16 to D16 as 30% of Stock X and 70% of Stock Z with again none of Stock Y. If you repeat this for a range of required expected returns, you should get the results shown in the table below.
Target Return 0.100 0.104 0.108 0.112 0.116 0.120 0.124 0.128 0.132 0.136 0.140 Stock X 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 Stock Y 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Stock Z 1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 Exp Return 0.100 0.104 0.108 0.112 0.116 0.120 0.124 0.128 0.132 0.136 0.140 Risk 0.080 0.082 0.088 0.097 0.109 0.122 0.136 0.151 0.167 0.183 0.200

Plotting the results for expected return and risk on a graph reveals the efficient frontier. The efficient frontier contains portfolios which are not dominated by any other portfolios.

Efficient Frontier
0.15
Stock X

0.14
Expected Return

0.13 0.12 0.11 0.10

St ock Z 0.33Stock X +0.33St ock Y +0.33St ock Z 0.5St ock X+0.5Stock Y

Stock Y

0.09 0.06

0.10

0.14 Risk (StDev)

0.18

0.22