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The Efficient Frontier: Markowitz Portfolio Optimization in Python

This post was originally featured on the Quantopian Blog and authored by Dr. Thomas Starke, David Edwards, and Dr. Thomas Wiecki.

Introduction

In this post you will learn about the basic idea behind Markowitz portfolio optimization as well as how to do it in Python. We will then show how you can create a simple backtest that rebalances its portfolio in a Markowitz-optimal way. We hope you enjoy it and get a little more enlightened in the process.

We will start by using random data and only later use actual stock data. This will hopefully help you to get a sense of how to use modelling and simulation to improve your understanding of the theoretical concepts. Don‘t forget that the skill of an algo-trader is to put mathematical models into code and this example is great practice.

Let's start with importing a few modules, which we need later and produce a series of normally distributed returns. cvxopt is a convex solver which you can easily download with sudo pip install cvxopt.

Simulations

%matplotlib inline
import numpy as np  
import matplotlib.pyplot as plt  
import cvxopt as opt  
from cvxopt import blas, solvers  
import pandas as pd

np.random.seed(123)

# Turn off progress printing  
solvers.options['show_progress'] = False  

Assume that we have 4 assets, each with a return series of length 1000. We can use numpy.random.randn to sample returns from a normal distribution.

## NUMBER OF ASSETS  
n_assets = 4

## NUMBER OF OBSERVATIONS  
n_obs = 1000

return_vec = np.random.randn(n_assets, n_obs)::: {.highlight .hl-ipython2}  
plt.plot(return_vec.T, alpha=.4);  
plt.xlabel('time')  
plt.ylabel('returns')  
matplotlib.text.Text at 0x7fa919b8c690  


These return series can be used to create a wide range of portfolios, which all have different returns and risks (standard deviation). We can produce a wide range of random weight vectors and plot those portfolios. As we want all our capital to be invested, this vector will have to sum to one.

def rand_weights(n):  
        ''' Produces n random weights that sum to 1 '''  
        k = np.random.rand(n)  
        return k / sum(k)

print rand_weights(n_assets)  
print rand_weights(n_assets)  
[ 0.54066805  0.2360283   0.11660484  0.1066988 ]
[ 0.27638339  0.03006307  0.47850085  0.21505269]

Next, lets evaluate how many of these random portfolios would perform. Towards this goal we are calculating the mean returns as well as the volatility (here we are using standard deviation). You can also see that there is a filter that only allows to plot portfolios with a standard deviation of < 2 for better illustration.

def random_portfolio(returns):  
    '''  
    Returns the mean and standard deviation of returns for a random portfolio  
    '''

    p = np.asmatrix(np.mean(returns, axis=1))  
    w = np.asmatrix(rand_weights(returns.shape[0]))  
    C = np.asmatrix(np.cov(returns))  
    mu = w * p.T  
    sigma = np.sqrt(w * C * w.T)  
    # This recursion reduces outliers to keep plots pretty  
    if sigma > 2:  
        return random_portfolio(returns)  
    return mu, sigma  

In the code you will notice the calculation of the return with:
\[R = p^T w\]

where R is the expected return, is the transpose of the vector for the mean returns for each time series and w is the weight vector of the portfolio. is a Nx1 column vector, so turns into a 1xN row vector which can be multiplied with the Nx1 weight (column) vector w to give a scalar result. This is equivalent to the dot product used in the code. Keep in mind that Python has a reversed definition of rows and columns and the accurate NumPy version of the previous equation would be R = w * p.T

Next, we calculate the standard deviation with
$$sigma = \sqrt{w^T C w}$$

where C is the covariance matrix of the returns which is a NxN matrix. Please note that if we simply calculated the simple standard deviation with the appropriate weighting using std(array(ret_vec).T*w) we would get a slightly different ’bullet’. This is because the simple standard deviation calculation would not take covariances into account. In the covariance matrix, the values of the diagonal represent the simple variances of each asset while the off-diagonals are the variances between the assets. By using ordinary std() we effectively only regard the diagonal and miss the rest. A small but significant difference.

Lets generate the mean returns and volatility for 500 random portfolios:

n_portfolios = 500  
means, stds = np.column_stack([  
    random_portfolio(return_vec)  
    for _ in xrange(n_portfolios)  
])

Upon plotting those you will observe that they form a characteristic parabolic shape called the ‘Markowitz bullet‘ with the boundaries being called the ‘efficient frontier‘, where we have the lowest variance for a given expected.

plt.plot(stds, means, 'o', markersize=5)  
plt.xlabel('std')  
plt.ylabel('mean')  
plt.title('Mean and standard deviation of returns of randomly generated portfolios')  

Markowitz optimization and the Efficient Frontier

Once we have a good representation of our portfolios as the blue dots show we can calculate the efficient frontier Markowitz-style. This is done by minimizing

$$w^T C w$$

for W on the expected portfolio return whilst keeping the sum of all the weights equal to 1:

$$\sum_{i}{w_i} = 1 $$

Here we parametrically run through R\^T w = mu and find the minimum variance for different mu‘s. This can be done with scipy.optimise.minimize but we have to define quite a complex problem with bounds, constraints and a Lagrange multiplier. Conveniently, the cvxopt package, a convex solver, does all of that for us. We used one of their examples with some modifications as shown below. You will notice that there are some conditioning expressions in the code. They are simply needed to set up the problem. For more information please have a look at the cvxopt example.

The mus vector produces a series of expected return values in a non-linear and more appropriate way. We will see later that we don‘t need to calculate a lot of these as they perfectly fit a parabola, which can safely be extrapolated for higher values.

def optimal_portfolio(returns):  
    n = len(returns)  
    returns = np.asmatrix(returns)  
    N = 100  
    mus = [10**(5.0 * t/N - 1.0) for t in range(N)]  
    # Convert to cvxopt matrices  
    S = opt.matrix(np.cov(returns))  
    pbar = opt.matrix(np.mean(returns, axis=1))  
    # Create constraint matrices  
    G = -opt.matrix(np.eye(n))   # negative n x n identity matrix  
    h = opt.matrix(0.0, (n ,1))  
    A = opt.matrix(1.0, (1, n))  
    b = opt.matrix(1.0)  
    # Calculate efficient frontier weights using quadratic programming  
    portfolios = [solvers.qp(mu*S, -pbar, G, h, A, b)['x']  
                  for mu in mus]  
    ## CALCULATE RISKS AND RETURNS FOR FRONTIER  
    returns = [blas.dot(pbar, x) for x in portfolios]  
    risks = [np.sqrt(blas.dot(x, S*x)) for x in portfolios]  
    ## CALCULATE THE 2ND DEGREE POLYNOMIAL OF THE FRONTIER CURVE  
    m1 = np.polyfit(returns, risks, 2)  
    x1 = np.sqrt(m1[2] / m1[0])  
    # CALCULATE THE OPTIMAL PORTFOLIO  
    wt = solvers.qp(opt.matrix(x1 * S), -pbar, G, h, A, b)['x']  
    return np.asarray(wt), returns, risks

weights, returns, risks = optimal_portfolio(return_vec)

plt.plot(stds, means, 'o')  
plt.ylabel('mean')  
plt.xlabel('std')  
plt.plot(risks, returns, 'y-o')  

In yellow you can see the optimal portfolios for each of the desired returns (i.e. the mus). In addition, we get the one optimal portfolio returned:

print weights  
[[  2.77880107e-09]
 [  3.20322848e-06]  
 [  1.54301198e-06]  
 [  9.99995251e-01]]  

Backtesting on real market data

This is all very interesting but not very applied. We next demonstrate how you can create a simple algorithm in zipline -- the open-source backtester that powers Quantopian -- to test this optimization on actual historical stock data.

First, lets load in some historical data using Quantopian's data (if we are running in the Quantopian Research Platform, or the load_bars_from_yahoo() function from zipline.

from zipline.utils.factory import load_bars_from_yahoo  
end = pd.Timestamp.utcnow()  
start = end - 2500 * pd.tseries.offsets.BDay()

data = load_bars_from_yahoo(stocks=['IBM', 'GLD', 'XOM', 'AAPL',  
                                    'MSFT', 'TLT', 'SHY'],  
                            start=start, end=end)  
IBM  
GLD  
XOM  
AAPL  
MSFT  
TLT  
SHY  
data.loc[:, :, 'price'].plot(figsize=(8,5))  
plt.ylabel('price in $')  

)

Next, we'll create a zipline algorithm by defining two functions -- initialize() which is called once before the simulation starts, and handle_data() which is called for every trading bar. We then instantiate the algorithm object.

If you are confused about the syntax of zipline, check out the tutorial.

import zipline  
from zipline.api import (history,  
                         set_slippage,  
                         slippage,  
                         set_commission,  
                         commission,  
                         order_target_percent)

from zipline import TradingAlgorithm


def initialize(context):  
    '''  
    Called once at the very beginning of a backtest (and live trading).  
    Use this method to set up any bookkeeping variables.  
    The context object is passed to all the other methods in your algorithm.

    Parameters

    context: An initialized and empty Python dictionary that has been  
             augmented so that properties can be accessed using dot  
             notation as well as the traditional bracket notation.  
    Returns None  
    '''  
    # Turn off the slippage model  
    set_slippage(slippage.FixedSlippage(spread=0.0))  
    # Set the commission model (Interactive Brokers Commission)  
    set_commission(commission.PerShare(cost=0.01, min_trade_cost=1.0))  
    context.tick = 0  
def handle_data(context, data):  
    '''  
    Called when a market event occurs for any of the algorithm's  
    securities. 

    Parameters

    data: A dictionary keyed by security id containing the current  
          state of the securities in the algo's universe.

    context: The same context object from the initialize function.  
             Stores the up to date portfolio as well as any state  
             variables defined.

    Returns None  
    '''  
    # Allow history to accumulate 100 days of prices before trading  
    # and rebalance every day thereafter.  
    context.tick += 1  
    if context.tick < 100:  
        return  
    # Get rolling window of past prices and compute returns  
    prices = history(100, '1d', 'price').dropna()  
    returns = prices.pct_change().dropna()  
    try:  
        # Perform Markowitz-style portfolio optimization  
        weights, _, _ = optimal_portfolio(returns.T)  
        # Rebalance portfolio accordingly  
        for stock, weight in zip(prices.columns, weights):  
            order_target_percent(stock, weight)  
    except ValueError as e:  
        # Sometimes this error is thrown  
        # ValueError: Rank(A) < p or Rank([P; A; G]) < n  
        pass  
# Instantinate algorithm  
algo = TradingAlgorithm(initialize=initialize,  
                        handle_data=handle_data)  
# Run algorithm  
results = algo.run(data)  
results.portfolio_value.plot()  
[2015-01-28 14:35:58.352355] INFO: Performance: Simulated 2411 trading days out of 2411.
[2015-01-28 14:35:58.352976] INFO: Performance: first open: 2005-06-29 13:31:00+00:00
[2015-01-28 14:35:58.353412] INFO: Performance: last close: 2015-01-27 21:00:00+00:00

As you can see, the performance here is pretty good, even through the 2008 financial crisis. This is most likely due to our universe selection and shouldn't always be expected. Increasing the number of stocks in the universe might reduce the volatility as well. Please let us know in the comments section if you had any success with this strategy and how many stocks you used.

Conclusions

In this blog, co-written by Quantopian friend Dr. Thomas Starke, we wanted to provide an intuitive and gentle introduction to Markowitz portfolio optimization which still remains relevant today. By using simulation of various random portfolios we have seen that certain portfolios perform better than others. Convex optimization using cvxopt allowed us to then numerically determine the portfolios that live on the efficient frontier. The zipline backtest serves as an example but also shows compelling performance.

Next Steps

  • Clone the notebook and run it on your own to see if you can enhance the performance. See here for a forum thread containing this Notebook on Quantopian.
  • You can also download just the notebook for use in your own environment here.
  • Read a recent interview with Harry Markowitz: What Does Harry Markowitz Think?
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