Proceedings of the 2023 International Conference on Management Research and Economic Development

DOI: 10.54254/2754-1169/25/20230495

Stock Analysis and Portfolio Optimization

Xingcong Liu1,a,*
1
College of Engineering and Mathematical Sciences, University of Vermont, Burlington, 05401,
USA
a. [email protected]
*corresponding author

Abstract: This paper investigates financial time series from US stock markets from a
quantitative perspective. The returns of all stocks are clustered with K-means with five
centroids; in each group, the store with the maximum return is selected. For all five chosen
supplies, construct the portfolio with different stock weights and optimize the combination
with Monte Carlo to mitigate risk and maximize the Sharpe ratio. Comparing the weights
under different stock weights concludes that the optimal portfolio can be obtained with the
maximized Sharpe ratio scenario. More interestingly, the consequences based on market
value also give remarkable cumulative returns.

Keywords: US stock market, K-means, Monte Carlo, sharp ratio

1. Introduction
The financial markets are usually unpredictable and full of uncertainties. Investment risk is a
significant concern in the financial markets [1]. And it is strongly related to the market laws of itself
and contingencies. National policies, natural disasters, and economic crises will impact the financial
market and the return on investment. As a result, the investors hope to find approaches to hinder
investment risks and improve returns simultaneously.
As ordinary people urgently need reasonable wealth distribution theory, learning to optimize
investment and financial management and achieve sound investment is the most concerned issue for
investors.
For investors, the investment goals typically are maximizing returns under given risks, and
different people perceive various risk preferences or just maximizing the cumulative returns during
the investment period. Risks and returns are constantly coming together; the most crucial part of
investment optimization is to find the optimal allocation of existing wealth resources among risky
investable assets within a given risk preference.
Regarding portfolio optimization, one of the essential subjects of modern finance is to
investigate how to rationally and reasonably purchase/allocate financial products in an uncertain
environment to achieve a desired equilibrium between yield and risk [2].
In financial history, portfolio theory is also called diversification investment theory [3,4]. As its
name indicates, diversification does not put all eggs in the same basket; it investigates the best way
for investors to distribute available funds when funds are restricted and expected returns are
undermined. Thereby avoiding the risks in the financial market and maximizing returns.

© 2023 The Authors. This is an open access article distributed under the terms of the Creative Commons Attribution License 4.0
(https://creativecommons.org/licenses/by/4.0/).

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Another way to understand investment is to exchange risk compensation (income) by assuming

certain risks. Generally speaking, with greater risk, the return will be improved. Hence, the
compromise between risk and return must be accepted when investors make investment decisions
based on their circumstances.
To realize the optimization of investment, quantifying the investment is usually a must, which
can be done in the quantitative investment field. Quantitative investment takes advantage of
computer science techniques and specific mathematical algorithms to evaluate investment ideas and
realize investment strategies [5]. In essence, quantitative investment is to observe the laws and
study the pattern of markets, then attempt to discover the relationship between various factors that
could help to determine future stock price returns.
2. Stock Dataset
The dataset of different stocks is obtained from the Python finance package. In this report, 27 stocks
are selected from 2010/01/02 to 2023/03/11 since not all the tickers are valid in this experiment.
The chosen 27 stocks are EOG Resources, Occidental Petroleum, Enbridge, NextEra-Energy,
Enterprise Products, Delta Air Lines, Biglari Holdings, Danaher Corporation, Paccar, Walmart,
Procter \& Gamble, Coca-Cola Company, Pepsi, Costco, Bank of America, Morgan Stanley, Unum,
Progressive, Master Card, Apple, Microsoft, Visa, Google, IBM, Netflix, Visteon, Verizon.

Figure 1: 27 stocks’ price trends from 2010/01/02 to 2023/03/11.

The overall trends of all the stocks are shown in Figure 1, it can be observed that the general
direction is almost the same, and in some critical time, for example, in 2019 and around 2021, due
to Covid, basically all the stocks go down drastically at the same time.
2.1. Calculate the Daily Rate of Return for a Stock
Calculate the stock's return daily, and the corresponding return curve. The daily return of a stock is
given by percentage change, it can be observed that around 2020, the minimal return occurs. Back
to the prices curve, the price goes down drastically. The most stable prices curve 'Unum' is also
stable in the return curve.

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3. K-means for Choosing Five Stocks

There are 27 stocks; however, instead of clustering the stocks based on different industries, we
explore this dataset from the data perspective. The k-means clustering is utilized to classify the
company into five groups. Then calculate the mean return of each stock as shown in Table 2

Table 1: The average return on 27 stocks.

Company mean return Company mean return
Netflix 0.001350 EOG Resources 0.000652
Apple 0.001068 Bank of America 0.000551
Master Card 0.001051 Unum 0.000546
Microsoft 0.000961 Paccar 0.000527
Visa 0.000940 Pepsi 0.000475
Progressive 0.000844 Walmart 0.000464
Costco 0.000813 Enterprise Products 0.000462
Visteon 0.000804 Occidental Petroleum 0.000453
Danaher Corporation 0.000774 Procter \& Gamble 0.000440
Google 0.000756 Enbridge 0.000410
NextEra-Energy 0.000741 Coca-Cola Company 0.000402
Delta Air Lines 0.000738 Biglari Holdings 0.000293
Morgan Stanley 0.000723 Verizon 0.000279
Company mean return
IBM 0.000228

In Table 2, all the mean returns are positive. And the largest returns happen in "Netflix" and
"Apple," which are quite similar. The k-means algorithm is universal, and here we mainly employ
such a method rather than study it; the Principal Component Analysis is used to reduce the
dimension of each stock return data into two dimensions for visualization. Then, the K-means
clustering method is responsible for clustering the 2-dimensional data into the desired number of
groups based on Euclidean distance [6]. In the PCA procedure, the time series value of each stock is
processed based on the following steps: Standardization is critical to perform standardization before
PCA since it's sensitive regarding variances of the initial variable. Compute the covariance matrix
to evaluate how much deviation or how many relationships between two variables. Obtain the
eigenvalues and eigenvectors of the covariance matrix to determine the principal components of the
data by ordering the percentage of explained variances.

Table 2: K-means results for five groups with maximizing mean returns.
Label Name Mean return
0 Costco 0.001051
1 Netflix 0.00135
2 Visteon 0.000804
3 Occidental Petroleum 0.000652
4 Microsoft 0.001068

The selected five groups are 'Costco,' 'Netflix,' 'Visteon,' 'Occidental Petroleum,' 'And Microsoft’
In Figure 2, reduced data are arranged in the black dot, and the centroids are depicted as a white
cross; different groups are shown with different colors.

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Figure 2: K-means clustering on five groups from 27 stocks.

With the k-means clustering on five groups, choose the maximum mean return in each group, as
shown in Table 2.
4. Portfolio Return Calculation
We have selected 5 stocks, and the number of preferred stocks is fixed. Next, we should consider
how we can allocate resources with unknown weights.
In this section, the portfolio return can be obtained by summating different stocks with weights.
First, we can get an initial return with random consequences to check how the portfolio performs.
4.1. Portfolio with a Given Weight
As explained before, the primary choice is to a set of weights manually, with the summation of each
value as unity. The weights corresponding to 5 individual stocks are 'Costco': 0.32, 'Netflix':0.15,
'Visteon':0.10, 'Occidental Petroleum':0.18, and 'Microsoft': 0.25. Incoming supplies are multiplied
by their calculated weight to obtain weighted stock return value; then, the summation of the
weighted income of five stocks is to get the payment of the portfolio investment.
In this program, the cumulative return curve drawing function cumulative_returns_plot() can be
defined, and the cumulative return curve of a given weight portfolio can be drawn.
4.2. Equally Weighted Portfolio
The second solution is to evenly distribute the weight of each stock so that they are all equal. This is
the easiest way to invest and can be used as a benchmark for other portfolios. The same calculation
method can be conducted with values of 0.2 for each stock.
4.3. Market Value-weighted Portfolio
This section will study the portfolio with the weighted market value of the stock. In other words,
stocks with higher market value correspond to greater weights, which are proportional to the market
shares. When these stocks perform well, the portfolio's performance will also improve.

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Figure 3: Portfolio returns on the market value-weighted portfolio.

5. Portfolio Correlation Analysis

5.1. Portfolio Correlation Matrix
We can utilize the correlation matrix to get the approximated linear correlation between multiple
stock price returns. In the Python Pandas package, this can be achieved by simply using the corr()
method.
Each entry in this matrix is the correlation coefficient of two selected stocks, ranging from -1 to
1. It can be observed that the diagonal entries of the matrix are always one since the correlation of
one store and itself is, of course, perfectly correlated. Furthermore, the correlation matrix is
symmetrical. Thanks to the Python package seaborn, the numerical correlation matrix can be
displayed as a heat map for observation.
It can be found that the most significant correlation happened in stock 'Costco' and stock
'Microsoft.' On the other hand, since the original 27 stocks are processed with PCA as well as k-
means, in other words, the similarity between the two stores in the different clusters has been
reduced before. As a result, it can explain that the correlation between the selected five stocks is
generally not high.

Figure 4: Portfolio Correlation Matrix.

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5.2. Portfolio Covariance Matrix

Compared with the correlation coefficient, which may only reflect the linear relationship between
two stocks. The covariance matrix contains more information about the uncertainties to inform us of
the volatility of the stocks.
The built-in function .cov() can be used in Python to get the covariance matrix for a given
pandas DataFrame.
5.3. Portfolio Standard Deviation
The standard deviation, the square root of the variance, is normally used to quantify volatility and
portfolio risk. There are some disputes about which quantity is the best to evaluate the risk.
However, variance is the most convenient one, and the risk can be estimated by

σ=��𝑤𝑤𝑤𝑤 � 𝑤𝑤� (1)

σ, the standard deviation of the portfolio

6. Explore the Optimal Portfolio of Stocks
What kind of combination weight should be chosen is the best? Is it to maximize profits? Or the
least risky? We need to weigh the two factors of risk and benefit comprehensively. The portfolio
theory proposed by Markowitz, a Nobel laureate in the research field of economics, is popularly
applied in portfolio selection and asset allocation. The mean-variance analysis method and efficient
frontier model in this theory would be used to find the optimal investment portfolio.
6.1. Simulate the Markowitz Model Using Monte Carlo
Mean-Variance Model in modern portfolio theory, also known as the mean-variance model, was
proposed by Harry Markowitz [7]. It's a mathematical model to evaluate a portfolio of assets to
maximize the expected return.
The essential idea is to diversify the investment; for an investor, the portfolio risk can simply be
reduced by holding combinations of different assets that are not perfectly correlated. It is the
diversification that guarantees the same expected return while keeping the risk at a low level.
In the mean-variance analysis, the calculation of the mean and variance of individual assets and
the portfolio will be studied. For example, one can compare which investments have the most
significant expected returns and lowest variance. Suppose an investor decides to purchase two
different investment portfolios: he first buys asset A with $300,000, whose return rate is 10%. The
other investment B, with the amount $300,000, whose expected return rate is 10%. Since he decides
to purchase the portfolio with $400,000, the weight of each asset can be obtained based on the
buying amount; as a result, for assets A, the weight is 0.75, and for Investment B, the weight is
0.25. Furthermore, the total expected return of this portfolio can be calculated simply with the
weighted sum, which gives us the expected return of this portfolio is 8.75%.
On the other hand, the variance of our portfolio is much more complex.
It cannot be the weighted summation of the two investment's clashes; since a correlation exists
between the two investments, other conflicts will be added. Suppose, in this case, the correlation of
the two assets is 0.5, and the standard deviation of investments A and B are 0.14, 0.07, respectively.
the variance of this portfolio is

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𝜎𝜎 2 = (25%2 ∗ 7%2 ) + (75%2 ∗ 14%2 ) + (2 ∗ 25% ∗∗ 75% ∗ 7% ∗ 14% ∗ 0.65) = 0.0137 (2)

the standard deviation = 0.1171, If the asset pairs correlate 0, the portfolio's risk takes the lowest
value; if the asset pairs correlate 1, it can give the highest possible standard deviation of portfolio
return.
As a result, it will be less risky than owning one type of financial asset.
The risk is measured by variance. What mean-variance analysis provides investors is the insight
to find the most significant return at a particular risk. Or, on the contrary, to find the slightest
chance at a given level of return based on different investment preferences.
For a portfolio (take three financial assets A, B, C as an example), the expected returns can be
obtained with

E�𝑅𝑅𝑝𝑝 � = 𝑤𝑤𝐴𝐴 𝐸𝐸(𝑅𝑅𝐴𝐴 ) + 𝑤𝑤𝐵𝐵 𝐸𝐸(𝑅𝑅𝐵𝐵 ) + 𝑤𝑤𝐶𝐶 𝐸𝐸(𝑅𝑅𝐶𝐶 ) (3)

on the other hand, the variance of the portfolio is

𝜎𝜎𝑝𝑝2 = 𝑤𝑤𝐴𝐴2 𝜎𝜎𝐴𝐴2 + 𝑤𝑤𝐵𝐵2 𝜎𝜎𝐵𝐵2 + 𝑤𝑤𝐶𝐶2 𝜎𝜎𝐶𝐶2 + 2𝑤𝑤𝐴𝐴 𝑤𝑤𝐵𝐵 𝜎𝜎𝐴𝐴 𝜎𝜎𝐵𝐵 𝜌𝜌𝐴𝐴𝐴𝐴 + 2𝑤𝑤𝐴𝐴 𝑤𝑤𝐶𝐶 𝜎𝜎𝐴𝐴 𝜎𝜎𝐶𝐶 𝜌𝜌𝐴𝐴𝐴𝐴 + 2𝑤𝑤𝐵𝐵 𝑤𝑤𝐶𝐶 𝜎𝜎𝐵𝐵 𝜎𝜎𝐶𝐶 𝜌𝜌𝐸𝐸 (4)

Monte Carlo simulation is used for analysis; that is, a collection of weights is randomly
generated, the income and standard deviation of the combination are calculated, and this procedure
is repeated many times (for example, 10,000 times) [8]. The income and standard deviation of each
combination is calculated. Plotted as a scatterplot.
The basic philosophy for investment is to find the balance between risk and return. Figure 5
depicts all the possible outcomes. Each point represents a portfolio case; the x-axis represents the
standard deviation of risk, and the y-axis represents the return rate. According to Markowitz's
portfolio theory, a rational investor consistently maximizes the expected return at a given level of
risk or minimizes the expected risk at a given level of return. Reflected in the figure is the efficient
frontier around the boundary. Only the points on the efficient frontier are the most efficient
portfolios. We now know rational investors will choose portfolios on the efficient frontier, the top
with minimal x value. Under this consideration, there are some strategies one may reckon on [9].
6.2. Portfolio with Minimal Investment Risk
One strategy is to choose the minimum risk portfolio (GMV portfolio). The word GMV comes from
the global minimum variance. In Figure 5, the red dot represents the GMV portfolio, and in this
case, the corresponding weights are Costco:0.6633156, Netflix:0.07523087, Visteon: 0.04465153,
Occidental Petroleum: 0.0942384, Microsoft: 0.1225636.

Figure 5: Portfolio with minimal investment risk.

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Calculated weights to achieve minimum risk portfolio are as follows, 'Costco':0.6633156,

'Netflix':0.07523087, 'Visteon':0.04465153, 'Occidental Petroleum': 0.0942384, 'Microsoft':
0.1225636. And the resulting portfolio curve is shown in Figure 6. the blue line refers to the initial
portfolio; in this case, the portfolio returns are the baseline. The orange line refers to the equally
weighted portfolio. The green line has the highest portfolio return since its' weights were based on
market values; in this case, the risk is out of consideration. Finally, the red line demonstrates the
GMV method; the return is not high since the potential risk is a significant consideration.

Figure 6: Portfolio Returns (red) with minimal investment risk.

6.3. Invest in the Best Portfolio

Nobel laureate William Sharp proposed Sharpe Ratio to help investors compare investment returns
and risks [10,11]. Rational investors generally fix the trouble they can bear and pursue the
maximum return; or improve the expected return and seek the minimum bet. So the Sharpe ratio
calculates the excess return per unit of total risk taken. Calculated as follows:

𝑅𝑅𝑝𝑝 − 𝑅𝑅𝑓𝑓
𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = (5)
𝜎𝜎𝑝𝑝

Rp return of the portfolio

Rf risk-free rate
𝜎𝜎𝑝𝑝 standard deviation of the portfolio's excess
The numerator calculates the delta, the excess return on investment compared to a benchmark
representative of the entire investment class. Standard deviation $\sigma_{p}$ of the denominator
refers to the volatility of the return, which agrees with risk. Since the higher volatility is equivalent
to higher risk, next, simply divide the mean of excess returns by its standard deviation to get the
Sharpe ratio, which measures return over the stake. In addition, the annualized Sharpe ratio can be
obtained by multiplying with √252 (252 refers to the trading days in one year)

𝑅𝑅𝑝𝑝 − 𝑅𝑅𝑓𝑓
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = √252 ∗ (6)
𝜎𝜎𝑝𝑝

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Figure 7: Portfolio Sharpe ratio.

Selection of Optimal Sharpe Ratio Combination is what we desire to discover a so-called optimal
balance between returns and risks. It's the Sharpe ratio that can assist us in conducting more clear
analysis. The Sharpe ratio gives us the excess return generated by each unit of risk. The first step is
to evaluate the Sharpe ratio equivalent to the fusion of the above Monte Carlo simulation and plot it
as the third variable in the return-risk scatter plot. Here, the visual clue of color is used to represent
the Sharpe ratio. It can be observed that there exists an edge for the high Sharpe ratio; in this region,
we also would like to find out the apex of such a convex shape and the resulting Figure 8.

Figure 8: Selection of sharpe optimal combination.

There are some important for using the Sharpe ratio; the Sharpe ratio can be used to evaluate a
portfolio's risk-adjusted performance. To explain if the excess returns of a given portfolio will be
responsible for the wise investment or just random luck. However, it's not the metric for us to
consider the Sharpe ratio as the "best" portfolio option here from a theoretical perspective.
We find that the combinations along the upper edge of the scatterplot have larger Sharpe ratios.
Then observe the mixture with the highest Sharpe ratio and draw it on the return-risk scatter
diagram. Sharpe Ratio grading thresholds have four levels: when less than 1, defined as bad, and

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when the ratio is from 1 to 2, we can regard it as adequate or just suitable since the excess return is
just more significant than the variance, while when Sharpe ratio is more extensive than two and less
than 3, this is much more favorable, when extensive than 4, it would be excellent, and it might
happen some cases.
To achieve the maximum Sharpe ratio of the portfolio, the following weights of five stocks can
be used, 'Costco': 48694022, 'Netflix': 0.13380845, 'Visteon': 0.00482005, 'Occidental Petroleum':
0.03527024, 'Microsoft': 0.33916104. The returns are generally hard to predict, while the
volatilities (standard deviation) and correlation tend to be more stable. So, we first consider to
minimizes the standard deviation. The GMV portfolio often outperforms the MSR portfolios out of
sample, while the MSR performs better for in-sample. In actual investment, out-of-sample results
are more crucial for us.
On the other hand, The MSR portfolio is popular in theory since it has a high historical Sharpe
ratio. Still, it can't guarantee that the portfolio will continue to have a good Sharpe ratio. In
conclusion, the GMV portfolio result is much more valuable for investment.
Even though the above discussions only contain stocks for our analysis, the essential idea
remains for more complex combinations. In an investment portfolio, various financial assets such as
shares, futures, ETFs, options, and derivatives will be held. The underlying risk/return level for
individual security will strongly affect the Sharpe ratio. And with diversification, stocks, shares, and
other financial instruments are combined to hedge. Suppose a hedge fund manager has a portfolio of
stocks (similar to what we discuss in the above sections), and the Sharpe ratio is 1.70. He added
some commodities to diversify the allocation with a rate of 0.8/0.2 for stock/items. As a result, the
Sharpe ratio is pushed up to 1.9.
In this case, although adjusting this portfolio would generally enhance the risk level, it pushes
the ratio up, resulting in a more preferable risk/reward circumstance; it's common for us to achieve
such a high ratio. On the other hand, when the change of a portfolio leads the balance to improve,
the portfolio addition, at the same time, potentially offers attractive returns.
In some sense, many financial analysts will evaluate the Sharpe ratio when hitting a much more
unacceptable risk level, then decide not to change the portfolio.

Figure 9: Portfolio Returns (purple) on selection of Sharpe Optimal Combination.

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7. Conclusion
In this report, the quantitative analysis of financial time series from the US stock markets involved
clustering the returns of all stocks using the K-means algorithm with five centroids. Within each
cluster, the store with the maximum return was selected. The selected five stocks were then used to
construct a portfolio with different stock weights. The combination was optimized using Monte
Carlo simulation while considering risk mitigation and maximizing the Sharpe ratio. The results
revealed that maximizing the Sharpe ratio scenario could achieve the optimal portfolio.
Additionally, the weights based on market value also presented remarkable cumulative returns.
Furthermore, plans also include incorporating more evaluation metrics to assess the performance
of the optimized portfolio. These metrics could include downside risk, value at risk (VaR), and
maximum drawdown. Additionally, incorporating factors such as company size, industry, and
financial ratios could further improve the accuracy of the portfolio optimization approach.
Future efforts in this area will focus on expanding the analysis to consider more stocks and
clusters. The aim is to improve the accuracy of the portfolio optimization algorithm and further
explore the possibilities of mitigating risk while maximizing returns. Moreover, the study seeks to
investigate the applicability of this approach in alternative markets and asset types. By doing so, the
research will contribute to developing a comprehensive portfolio optimization strategy for investors.
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