Anatomy of Machines for Markowitz: Decision-Focused Learning for Mean-Variance Portfolio Optimization

Markowitz laid the foundation of portfolio theory through the mean-variance optimization (MVO) framework. However, the effectiveness of MVO is contingent on the precise estimation of expected returns, variances, and covariances of asset returns, which are typically uncertain. Machine learning models are becoming useful in estimating uncertain parameters, and such models are trained to minimize prediction errors, such as mean squared errors (MSE), which treat prediction errors uniformly across assets. Recent studies have pointed out that this approach would lead to suboptimal decisions and proposed Decision-Focused Learning (DFL) as a solution, integrating prediction and optimization to improve decision-making outcomes. While studies have shown DFL's potential to enhance portfolio performance, the detailed mechanisms of how DFL modifies prediction models for MVO remain unexplored. This study aims to investigate how DFL adjusts stock return prediction models to optimize decisions in MVO, addressing the question: "MSE treats the errors of all assets equally, but how does DFL reduce errors of different assets differently?" Answering this will provide crucial insights into optimal stock return prediction for constructing efficient portfolios.