In addition to the efficient frontier, an area of indifference should be considered during portfolio construction. An area of indifference is a method used to compare the characteristics of an investor’s current portfolio to characteristics for a set of proposed target portfolios. The investor is made aware of all available opportunities, while still maintaining a relevant reference point to base practical and realistic decisions on – in this case, the efficient frontier portfolios.
By considering an area of indifference coupled with random portfolio generation techniques when investigating how to improve a portfolio, we can consider a broad range of portfolios that have similar statistical properties, in a range around the current portfolio that extends towards the optimal portfolio on the efficient frontier. This allows us to identify whether the proposed changes will improve the expected outcomes with sufficient reliability, after the change in alteration costs is accounted for.
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