Given a portfolio consisting of two assets with the following features...

Expected Return
Volatility Correlation
Asset1 15% 25% 70%
Asset2 10% 15%

...and a certain minimum return that we want to earn...

rmin 2%

...we build the efficient frontier and select the frontier portfolio which minimizes the probability of not
achieving our minimum return...

In the literature, this procedure is also known as the "Roy Criterion". Unfortunately, the simple
portfolio construction technique used in this illustration is only applicable when returns are
(multivariate) normal distributed. Contrary to Markowitz portfolio construction, we do not make
explicit assumptions about the utility function of the investor; we assume that his risk preferences
are adequatly represented by the minimum return and shortfall probability.

w1 w2 ep vp
(rp-rmin)/vpprob(rp<rmin)
100% 0% 15.00% 25.00% 0.5200 30.15%
95% 5% 14.75% 24.28% 0.5251 29.98%
Shortfall
90% 10% Probability
14.50% Minimization
23.57% 0.5302 29.80%
85% 15% 14.25% 22.88% 0.5354
riance efficient portfolio with minimal shortfall probability of 29.62%
achieving a given minimu
20% 80% 20% 14.00% 22.20% 0.5405 29.44%
30.5%
75% 25% 13.75% 21.54% 0.5454 29.27%
18% 70% 30% 13.50% 20.90% 0.5503 29.11%
30.0%
16% 65% 35% 13.25% 20.27% 0.5549 28.95%

Shortfall Probability
14%
60% 40% 13.00% 19.67% 0.5592 28.80%
29.5%
55% 45% 12.75% 19.09% 0.5630 28.67%
12% 50% 50% 12.50% 18.54% 0.5663 28.56%
29.0%
Return

10% 45% 55% 12.25% 18.02% 0.5690 28.47%

40% 60% 12.00% 17.52% 0.5707 28.41%
28.5%
8%
35% 65% 11.75% 17.06% 0.5715 28.38%
6% 30% 70% 11.50% 16.64% 0.5711 28.0%
28.40%
4% 25% 75% 11.25% 16.25% 0.5692 28.46%
20% 80% 11.00% 15.91% 0.5658 27.5%
28.58%
2%
15% 85% 10.75% 15.61% 0.5607 28.75%
0% 10% 90% 10.50% 15.35% 0.5536 27.0%
28.99%
0% 5%5% 10%
95% 15%
10.25% 20%
15.15% 25%
0.5445 30%
29.30%
0% 100% Volatility
10.00% 15.00% 0.5333 29.69%

max[(rp-rmin)/vp]
Shortfall Risk Frontier 14
16%
minimum return 2% 0%
14% optimal portfolio 12% 17%
another portfolio 0.18
with same shortfall
28% prob
12%

10%
Return

8%

6%
 12%

10%

Return
8%

6%

4%

2%

0%
28.0% 28.5% 29.0% 29.5% 30.0% 30.5%
Shortfall Probability
 the probability of not

tely, the simple

returns are
, we do not make
his risk preferences
30.5%