Part 2

1. Sarah should respond to my suggestion:

Diversification lower risk dramatically by investing in stocks that have opposing correlations.
This will allow for the return on the portfolio to be based off various stocks and factos, as
opposed to investing wholly in East Coast Yachts stock where the return of the investment is
directly based on any fluctuations caused by East Coast Yachts. In spite of whatever beliefs
the investor may have about management, future market share, etc, if we adjust the expected
return f East Coast Yachts for risk, we notice that it is significantly lower than all the funds
that investment company offers
2. Since Bond fund is not a risk free-asset, for the purpose of diversification we want to find
some other assets that makes the correlation between them as small as possible so that we
can minimize the systematic risk

1. What advantages do the mutual funds offer compared to the company stock?
Investment in mutual funds could reduce the risk for investors by diversification. Never put
all eggs into one basket.
-

Cost reduction

Mutual funds which are specialized in trading in the stock market, they could lower the cost
for investor because the costs of trades are spread over all investor in the funds
-

Profitability

Mutual funds have many experts that could earn a profit for investors. They always carefully
researched to make a good decision
The company is currently private and is not expected to go public for 3 to 4 years. It would be
harder to gather historical data on performance. Also, the board of directors currently sets the
stock price so the market value will be harder to predict.
2. The advantages and disadvantages of choosing the Bledsoe Large Company Stock Fund
compared to the Bledsoe S&P 500 Index Fund:
Bledsoe Large Company Stock Fund:
- Advantages: Has outperformed the Market (essentially the S&P 500) in six of the last eight
years.

- Disadvantages: Charges 1.5% in expenses as opposed to the Bledsoe S&P 500s charge of
0.15% in expenses
4. The returns on the Bledsoe Small Cap Fund are the most volatile of all the mutual funds
offered in the 40l(k) plan. Why would you ever want to invest in this fund? When you examine
the expenses of the mutual funds, you will notice that this fund also has the highest expenses.
Does this affect your decision to invest in this fund?
- An investor may want to invest in this fund to diversify their portfolio. Diversification means
the risk for investors will reduce. Additionally, an investor may want to invest in this fund to get
higher return due to the higher risk incurred from the volatility. An investor who is not
extremely risk averse may choose to expose themselves to this risk given the potential increase
in reward. Furthermore, Investing in the Bledsoe Small-Cap fund has to deal with personal risk
tolerance. A conservative investor might not want to invest
- Higher expenses for a fund such as this should be expected given the nature of the assets to be
managed. Small cap stocks and increased volatility will most likely require more time and effort
on behalf of the asset manager and as a result would require more compensation. Personally, I
would not let the slightly higher expense charges affect my decision to invest in this fund if it
was needed for diversification. There is only a 0.20% difference in the expenses charged
between this fund and the Bledsoe Large Company Stock Fund. Besides that, 10 percent of its
assets is invested in companies based outside the United State, this could incur extra cost for the
fund.

5. A measure of risk-adjusted performance that is often used is the Sharpe ratio. The Sharpe ratio
is calculated as the risk premium of an asset divided by its standard deviation. The standard
deviation and return of the funds over the past 10 years are listed below. Calculate the Sharpe
ratio for each of these funds. Assume that the expected return and standard deviation of the
company stock will be 15 percent and 65 percent, respectively. Calculate the Sharpe ratio for the
company stock. How appropriate is the Sharpe ratio for these assets? When would you use the
Sharpe ratio?
10Year Annual ReturnRisk Free Rate
Sharp Ratio =
Standard deviation

Bledsoe S&P 500 Indexd Fund

Bledsoe Small Cap Fund
Bledsoe Large Company Stock Fund
Bledsoe Bond Fund
Company Stock
Risk Free Rate

10-Year Annual Return

10.15%
14.84%
11.08%
8.15%
15%
3.70%

Standard
Deviation
23.85%
29.62%
26.73%
10.34%
65.00%

Sharp Ratio
0.2704
0.3761
0.2761
0.4304
0.1738

The Sharpe ratio will work to give you a general idea of which fund is optimal, but is probably
not the best method to use with the data provided. The data provided is historical data or realized
returns and are generally not equal to expected returns. The Sharpe ratio would be more
appropriate to use if you have data that provides a forecast of expected returns. Historical data is
helpful, but historical performance is not always an indicator of future performance.
6. What portfolio allocation would you choose? Why? Explain your thinking carefully.
If I were going to develop a portfolio out of the fund choices above, I would use a combination
of the Bledsoe Small Cap, Bledsoe S&P 500 and Bledsoe Bond. I would select this combination
to help diversify my portfolio. I selected the Small Cap Fund as because of its relatively high
returns, the S&P 500 Fund based on its moderate returns and low (0.15%) expenses and the
Bond Fund to reduce portfolio volatility and higher Sharpe ratio.
I would choose to not invest in the Bledsoe Large Cap Fund based on its similarity to the
Bledsoe S&P 500. Additionally, the Large Cap fund charges an expense of 1.50% and has
historically outperformed the S&P 500 fund by only 0.93%. The S&P 500 fund charges only
0.15%. When you compare the returns of the two and factor in expenses the Large Cap Fund
actually returns 0.42% less.
I would choose not to invest in the Company Stock based on volatility alone. The 10 year return
is only 0.17% higher than the Small Cap Fund and essentially twice as volatile. If you assume
normal distribution, using the 10 year return as the average, there is a 40.87% chance that you
will lose money on this investment.

PART 2

1. Considering the effects of diversification, how should Sarah respond to the suggestion
that you invest 100 percent of your 401(k) account in East Coast Yachts stock?
Sarah should respond to my suggestion:
Even though you are confident in managements ability to lead the company and you should
support your employer, it may not be the wisest financial decision when considering investing
for your future, given the high standard deviation in the past, especially considering you are a
conservative investor. She should persuade you to diversify your portfolio to minimize your
exposure to unsystematic risk at East Coast Yachts. Diversification lower risk dramatically by
investing in stocks that have opposing correlations.

In spite of whatever beliefs the investor may have about management, future market share. If we
adjust the expected return East Coast Yachts for risk, we notice that it is significantly lower than
all the funds than that investment company offers

2. After hearing Sarah's response to investing your 401(k) account entirely in East Coast Yachts
stock, she has convinced you that this may not be the best alternative. Since you are a
conservative investor, you tell Sarah that a 100 percent investment in the bond fund may be the
best alternative. Is it?
The Bledsoe Bond Fund does appear to be the most optimal choice for a single fund investment,
based on the Sharpe ratio. You should also consider the fact that by choosing to invest this way
will result in lower returns on your investment, on average. Again, a better choice would be to
use a combination of the funds to diversify your portfolio.
3. Using the returns for the Bledsoe large-Cap Stock Fund and the Bledsoe Bond Fund, graph
the opportunity set of feasible portfolios.
See Excel Spreadsheet for calculations.

4. After examining the opportunity set, you notice that you can invest in a portfolio consisting of
the bond fund and the large-cap stock fund that will have exactly the same standard deviation as
the bond fund. This portfolio will also have a greater expected return. What are the portfolio
weights and expected return of this portfolio?
The opportunity set that I came up with did not have exactly the same standard deviation as the
Bond Fund, but one was extremely close (could be rounding). The portfolio combination was
20% Large Cap Stock Fund and 80% Bond Fund. This combination would provide an expected
return of 8.74% vs the 8.15% expected return of the Bond Fund.
5. Examining the opportunity set, notice there is a portfolio that has the lowest standard
deviation. This is the minimum variance portfolio. What are the portfolio weights, expected
return, and standard deviation of this portfolio? Why is the minimum variance portfolio
important?
The portfolio combination that has the lowest standard deviation is 10% Large Cap Stock Fund
and 90% Bond Fund. Expected return is 8.44%, Standard Deviation is 10.08%. Minimum
variance is important because once you know the portfolio with the minimum variance, you can
identify that point (portfolio) on the graph and the section of the opportunity set above the
minimum variance portfolio is the efficient frontier.

6. A measure of risk-adjusted performance that is often used is the Sharpe ratio. The Sharpe ratio
is calculated as the risk premium of an asset divided by its standard deviation. The portfolio with
the highest possible Sharpe ratio on the opportunity set is called the Sharpe optimal portfolio.
What are the portfolio weights, expected return, and standard deviation of the Sharpe optimal
portfolio? How does the Sharpe ratio of this portfolio compare to the Sharpe ratio of the bond
fund and the large-cap stock fund? Do you see a connection between the Sharpe optimal
portfolio and the CAPM? What is the connection?
Portfolio
Bledsoe Large Cap

Bledsoe Bond ER P Variance

Risk/ StDev

0%

100% 8.15% 0.01069

10.34%

43.04%

10%

90%

8.44% 0.01017

10.08%

47.03%

20%

80%

8.74% 0.01112

10.55%

47.76%

30%

70%

9.03% 0.01353

11.63%

45.81%

40%

60%

9.32% 0.01740

13.19%

42.62%

50%

50%

9.62% 0.02275

15.08%

39.22%

60%

40%

9.91% 0.02956

17.19%

36.11%

70%

30%

10.20%

0.03783

19.45%

33.42%

80%

20%

10.49%

0.04757

21.81%

31.15%

90%

10%

10.79%

0.05878

24.24%

29.23%

11.08%

0.07145

26.73%

27.61%

100% 0%

Sharpe Ratio

The Sharpe optimal portfolio (highlighted above in red) would be 20% Bledsoe Large Cap Fund
and 80% Bledsoe Bond Fund. The expected return of this portfolio is 8.74%. The standard
deviation is 10.55%.
The Sharpe ratio of this portfolio is slightly higher (4.72%) than the Bledsoe Bond fund and
significantly higher (20.15%) than the Bledsoe Large Cap Fund.
The Sharpe optimal portfolio (portfolio with highest Sharpe ratio) is on the efficient frontier,
according to CAPM.