Maximum Entropy Approach to Portfolio Optimization: Economic Justification of an Intuitive Diversity Idea

Abstract

The traditional Markowitz approach to portfolio optimization assumes that we know the means, variances, and covariances of the return rates of
all the financial instruments. In some practical situations, however, we do not have enough information to determine the variances and covariances, we only know the means. To provide a reasonable portfolio allocation for such cases, researchers proposed a heuristic maximum entropy approach. In this paper, we provide an economic justification for this heuristic idea.