By now we are familiar with the basics of the **R** language. We know how to analyze data, call its built-in functions, and apply them to the selected problems in a time series analysis. In this chapter we will use and extend this knowledge to discuss an important practical application: portfolio optimization, or in other words, security selection. This section covers the idea behind portfolio optimization: the mathematical models and theoretical solutions. To improve programming skills, we will implement an algorithm line by line using real data to solve a real-world example. We will also use the pre-written R packages on the same data set.

Imagine that we live in a tropical island and have only USD 100 to invest. Investment possibilities on the island are very limited; we can invest our entire fund into either ice creams or umbrellas. The payoffs that depend on the weather are as follows:

weather |
ice cream |
umbrella |
---|---|---|

sunny |
120 |
90 |

rainy |
90 |
120 |

Suppose...