# Random Portfolios vs Efficient Frontier

I understand the concept of the efficient frontier and am able to calculate it in Python. But even when generating 50'000 random 10 asset portfolios, the single portfolios are not even close to the efficient frontier.

I see that, for example, the maximum sharpe ratio portfolio has very pronounced allocation (most of the 10 asset get 0 allocation).

Since this work is very critical for myself I just wanted to ask the community if you experienced similar behaviour? Is it normal that when generating random portfolios not even one lies near the efficient frontier?

Please find the code below:

def portfolio_annualised_performance(weights, mean_returns, cov_matrix):
returns = np.sum(mean_returns*weights )
std = np.sqrt(np.dot(weights.T, np.dot(cov_matrix, weights)))
return std, returns

def random_portfolios(num_portfolios, mean_returns, cov_matrix, risk_free_rate):
results = np.zeros((3,num_portfolios))
weights_record = []
for i in range(num_portfolios):
weights = abs(np.random.randn(len(mean_returns)))
weights /= np.sum(weights)
weights_record.append(weights)
portfolio_std_dev, portfolio_return = portfolio_annualised_performance(weights, mean_returns, cov_matrix)
results[0,i] = portfolio_std_dev
results[1,i] = portfolio_return
results[2,i] = (portfolio_return - risk_free_rate) / portfolio_std_dev
return results, weights_record

def neg_sharpe_ratio(weights, mean_returns, cov_matrix, risk_free_rate):
p_var, p_ret = portfolio_annualised_performance(weights, mean_returns, cov_matrix)
return -(p_ret - risk_free_rate) / p_var

def max_sharpe_ratio(mean_returns, cov_matrix, risk_free_rate):
num_assets = len(mean_returns)
args = (mean_returns, cov_matrix, risk_free_rate)
constraints = ({'type': 'eq', 'fun': lambda x: np.sum(x) - 1})
bound = (0.0,1.0)
bounds = tuple(bound for asset in range(num_assets))
result = sco.minimize(neg_sharpe_ratio, num_assets*[1./num_assets,], args=args,
method='SLSQP', bounds=bounds, constraints=constraints)
return result

def portfolio_volatility(weights, mean_returns, cov_matrix):
return portfolio_annualised_performance(weights, mean_returns, cov_matrix)[0]

def min_variance(mean_returns, cov_matrix):
num_assets = len(mean_returns)
args = (mean_returns, cov_matrix)
constraints = ({'type': 'eq', 'fun': lambda x: np.sum(x) - 1})
bound = (0.0,1.0)
bounds = tuple(bound for asset in range(num_assets))

result = sco.minimize(portfolio_volatility, num_assets*[1./num_assets,], args=args,
method='SLSQP', bounds=bounds, constraints=constraints)
return result

def efficient_return(mean_returns, cov_matrix, target):
num_assets = len(mean_returns)
args = (mean_returns, cov_matrix)

def portfolio_return(weights):
return portfolio_annualised_performance(weights, mean_returns, cov_matrix)[1]

constraints = ({'type': 'eq', 'fun': lambda x: portfolio_return(x) - target},
{'type': 'eq', 'fun': lambda x: np.sum(x) - 1})
bounds = tuple((0.0,1) for asset in range(num_assets))
result = sco.minimize(portfolio_volatility, num_assets*[1./num_assets,], args=args, method='SLSQP', bounds=bounds, constraints=constraints)
return result

def efficient_frontier(mean_returns, cov_matrix, returns_range):
efficients = []
for ret in returns_range:
efficients.append(efficient_return(mean_returns, cov_matrix, ret))
return efficients

def display_calculated_ef_with_random(mean_returns, cov_matrix, num_portfolios, risk_free_rate):
results, _ = random_portfolios(num_portfolios,mean_returns, cov_matrix, risk_free_rate)

max_sharpe = max_sharpe_ratio(mean_returns, cov_matrix, risk_free_rate)
sdp, rp = portfolio_annualised_performance(max_sharpe['x'], mean_returns, cov_matrix)
max_sharpe_allocation = pd.DataFrame(max_sharpe.x,index=curr_w_terms,columns=['allocation'])
max_sharpe_allocation.allocation = [round(i*100,4)for i in max_sharpe_allocation.allocation]
max_sharpe_allocation = max_sharpe_allocation.T

min_vol = min_variance(mean_returns, cov_matrix)
sdp_min, rp_min = portfolio_annualised_performance(min_vol['x'], mean_returns, cov_matrix)
min_vol_allocation = pd.DataFrame(min_vol.x,index=curr_w_terms,columns=['allocation'])
min_vol_allocation.allocation = [round(i*100,4)for i in min_vol_allocation.allocation]
min_vol_allocation = min_vol_allocation.T

print("-"*80)
print("Maximum Sharpe Ratio Portfolio Allocation\n")
print("Annualised Return:", round(rp,4))
print("Annualised Volatility:", round(sdp,4))
print("\n")
print(max_sharpe_allocation)
print("-"*80)
print("Minimum Volatility Portfolio Allocation\n")
print("Annualised Return:", round(rp_min,4))
print("Annualised Volatility:", round(sdp_min,4))
print("\n")
print(min_vol_allocation)

plt.figure(figsize=(10, 7))
plt.scatter(results[0,:],results[1,:],c=results[2,:],cmap='YlGnBu', marker='o', s=10, alpha=0.3)
plt.colorbar()
plt.scatter(sdp,rp,marker='*',color='r',s=500, label='Maximum Sharpe ratio')
plt.scatter(sdp_min,rp_min,marker='*',color='g',s=500, label='Minimum volatility')

target = np.linspace(rp_min, 0.05, 20)
efficient_portfolios = efficient_frontier(mean_returns, cov_matrix, target)
plt.plot([p['fun'] for p in efficient_portfolios], target, linestyle='-.', color='black', label='efficient frontier')
plt.title('Calculated Portfolio Optimization based on Efficient Frontier')
plt.xlabel('annualised volatility')
plt.ylabel('annualised returns')
plt.legend(labelspacing=0.8)
plt.ylim([-0.005,0.03])
plt.xlim([0.0,0.05])

display_calculated_ef_with_random(log_ret, new_cov, 50000, 0)


I haven't annualised the Covar-Matrix since I already have annual return estimates as well as covar estimates.

My very question is: is this plausible or not?

EDIT Since the weight generation process of my random portfolios seems to preffer too similar portfolio I changed the following function:

def random_portfolios(num_portfolios, mean_returns, cov_matrix, risk_free_rate):
results = np.zeros((3,num_portfolios))
weights_record = []
for i in range(num_portfolios):
weights = abs(np.random.randn(len(mean_returns)))
weights[weights<1] = 0
if sum(weights)==0:
print("sum=0")
indexes = np.unique(np.random.randint(0,10,3)).tolist()
weights[indexes] = abs(np.random.randn(len(indexes)))
weights /= np.sum(weights)
weights_record.append(weights)
portfolio_std_dev, portfolio_return = portfolio_annualised_performance(weights, mean_returns, cov_matrix)
results[0,i] = portfolio_std_dev
results[1,i] = portfolio_return
results[2,i] = (portfolio_return - risk_free_rate) / portfolio_std_dev
return results, weights_record


After doing so, the Portfolios are way better distributed:

So, can we then agree that the above code does what it should and I can continue from here?

• I don't like your method of generating random weights. It is biased towards the equal weight portfolio and does not cover the entire simplex evenly. Jun 2 '19 at 17:02
• any suggestion how to overcome this? Jun 2 '19 at 17:14
• Is this purely a bond portfolio? Jun 2 '19 at 20:22
• @Dave Harris: yes it is. Does that make any difference? Jun 3 '19 at 3:35
• Yes, it does make a difference. The efficient frontier has been falsified, extensively, for all equity-like securities. Returns on equity lack a first moment. If I were doing what you are doing, instead of a price covariance, which is an historical statement anyway. I would look at the probability of default and covariance matrix from that. After all, for fixed rate bonds, the only thing that matters is non-payment. The forward default risk is the real risk with bonds assuming no liquidity crisis. Jun 3 '19 at 4:04

You seem to have two distinct problems:

1. How to generate random portfolios
2. How optimal portfolios are structured

A straightforward way to simulate the weights of random portfolios is to use the Dirichlet distribution $$Dir(\alpha_1,\ldots,\alpha_n)$$. This is a distribution on the Simplex (i.e. on $$S=\{x\in\mathbb{R}^n | \sum x_i =1, x_i\geq 0\}$$, which can give you very diversified as well as very concentrated portfolios. Setting all $$\alpha_i=1$$ gives you the uniform distribution on the simplex, making some $$\alpha_i$$ smaller will give you portfolios concentrated in those assets making $$\alpha_i$$ larger more diversified allocations. All pertinent facts about $$Dir(\alpha_1,\ldots,\alpha_n)$$ can be found in the Wikipedia article.

Below are two plots of densities for different choices of an exchangeable Dirichlet density for the two-Simplex (which is a triangle in space):

Your "optimal" portfolio will depend on your optimisation criterion and the joint asset returns. So I doubt anyone can make non-trivial general statements. But optimal portfolios by definition are extreme. Hence it is not surprising for them to be non-generic. Judging from my experience, Sharpe ratio does indeed favour very imbalanced portfolios with little diversification.

• is there an article that promotes dirichlet for simulating random portfolio weights specifically? Aug 14 '20 at 19:15

No need to invent your own algorithm for random portfolio weights. There is a very simple algorithm to generate a random point in a simplex (i.e. to generate $$e_i,i=1,k$$ such that $$e_i\ge 0$$ and $$\sum_{i=1}^k e_i=1$$). It is due to Rubinstein and Melamed (1998):

1. Generate k independent exponential random variables $$Y_1,\cdots,Y_k$$ (for example they can be generated from uniformly (0,1) distributed variables U by taking $$Y_i=-\ln(U_i)$$).

2. Compute the total $$T=\sum_{i=1}^k Y_i$$

3. Define $$E_i=Y_i/T$$ and return $$E$$ as the desired vector of random portfolio weights.

(For a published reference see this link https://ie.technion.ac.il/~onn/Selected/AOR09.pdf)