The Sherman-Morrison-Markowitz Portfolio

TL;DR

This paper introduces the Sherman-Morrison-Markowitz portfolio, which simplifies the classical Markowitz approach using the Sherman-Morrison identity and uncentered moments, with implications for multi-period optimization.

Contribution

It demonstrates that the Markowitz portfolio can be expressed as a scalar multiple of a portfolio using the second moment matrix, extending the theory to constrained and multi-period settings.

Findings

The Sherman-Morrison-Markowitz portfolio closely approximates the classical Markowitz portfolio.

Replacing covariance with second moments is more natural in multi-period optimization.

The practical impact of the new approach is small but theoretically significant.

Abstract

We show that the Markowitz portfolio is a scalar multiple of another portfolio which replaces the covariance with the second moment matrix, via simple application of the Sherman-Morrison identity. Moreover it is shown that when using conditional estimates of the first two moments, this "Sherman-Morrison-Markowitz" portfolio solves the standard unconditional portfolio optimization problems. We argue that in multi-period portfolio optimization problems it is more natural to replace variance and covariance with their uncentered counterparts. We extend the theory to deal with constraints in expectation, where we find a decomposition of squared effects into spanned and orthogonal components. Compared to the Markowitz portfolio, the Sherman-Morrison-Markowitz portfolio downlevers by a small amount that depends on the conditional squared maximal Sharpe ratio; the practical impact will be fairly small, however. We present some example use cases for the theory.