Portfolio Selection Based on Return, Risk, and Relative Performance

Markowitz introduced the concept of portfolio selection based on return and variance. Recognition that many investors evaluate performance relative to a benchmark led to the idea of portfolio selection based on return and relative risk. For many investors, both approaches fail to yield satisfactory results. Although they acknowledge the importance of benchmarks in the decision process, they are not indifferent to the variance of absolute returns. In this situation, a utility function that measures return, variance, and tracking error is more appropriate. Analysis of this utility function shows that its set of efficient portfolios includes the mean–variance efficient set, the mean-tracking-error efficient set, and all convex combinations of these two sets. Optimization with this utility function may find solutions that investors will actually use.