Making Optimal Choices, or Just Making Choices? Part 3

Part 2 of this blog ended with me very quickly stating that the MotoGP tipping comp optimiser was identical in structure to a portfolio optimisation problem, where the portfolio could contain stock or other assets, or even projects. Let’s look at this in a little more detail as I’m sure you’re reading this to find how to optimise your own decisions rather than wondering how I went in the tipping competition!

In my model there was a fixed budget (though less could be spent if desired) to spend on riders, with the aim of maximising their total points haul. In the real world you may have a total budget of say $100m to invest in a range of projects perhaps many hundreds of millions of dollars in total value each of which have certain expected returns. At its simplest this decision evaluation will find the most (expected) profitable portfolio of the projects. This is an inclusion/exclusion grouping model, but it is very simple to optimise assets with a continuous level e.g. the amount of money invested in various shares etc. Another real example I have seen when working with an investment company here in Australia was a model whose goal was simply to find the portfolio mix that came closest to the total allowable spend without exceeding it.

Further realism can be included by using constraints should there be the need. A resource constraint may mean there has to be a limit to the number of projects that can be run simultaneously. There may also be a minimum number of projects determined by management as a mitigation strategy. Such constraints are very simple to employ using Evolver and add value to the decision analysis without the need to provide specific risk analysis/Monte Carlo simulation information for the model.

A slightly more sophisticated method of turning an optimisation into a useful portfolio risk management tool where uncertainty hasn’t been specifically modelled is to estimate the possible downside of each asset and include it in the calculation of the portfolio’s ‘score’. The Evolver software comes standard with over twenty example spreadsheets for your educational pleasure, of which “Portfolio Mix.xls” gives one method for doing just this.
In the next (and final) instalment of the Making Optimal Choices blog I will explore the idea that not all optimisations no matter how mathematically correct will produce the same results in good time, and that elegant modelling should always be the goal prior to firing up Evolver.

And so you know, I came second in the competition. Next year I’m hoping to go one better!

» Making Optimal Choices, Part 1
» Making Optimal Choices, Part 2

Rishi Prabhakar
Trainer/Consultant

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