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Week 4
Sharpe Ratio = (R-Rf)/(Vol). We may use the Sharpe ratio as a criteria for determining the right portfolio.
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Portfolio Return
0.15 0.1 CAL 0.05 0 0 0.05 0.1 0.15 0.2 Portfolio Volatility
How to allocate between the riskfree asset and the risky stock portfolio.
The conclusion we draw from the straight-line graph is that: when we combine a riskfree asset with the risky stock portfolio, all portfolios have the same Sharpe ratio. Therefore, it is not possible to make a decision on allocation between the riskfree asset and the risky stock portfolio based solely on the Sharpe ratio. Instead, we will have to take into account individualspecific considerations. There is no single allocation here that is best for all investors. Your decision to allocate between the risky asset and the riskfree asset will be determined by your level of risk aversion and your objectives, depending on factors like your age, wealth, horizon, etc. The more risk averse you are, the less you will invest in the risky asset. Although different investors may differ in the level of risk they take, they are also alike in that each investor faces exactly the same riskreturn tradeoff.
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Volatility-Return Frontier
Consider the graph of the portfolio return vs. Portfolio volatility. Graphically, the optimal portfolio (with the highest Sharpe ratio) is the portfolio that lies on a tangent to the graph. This tangent is drawn so that it has the riskfree rate as its intercept. This is because the slope of the line that passes connects the riskfree asset and the risky portfolio is equal to the Sharpe ratio. Thus, the steeper the line, the higher the Sharpe ratio. The tangent to the graph has the steepest slope, and thus the portfolio that lies on this tangent is the optimal portfolio (having the highest Sharpe ratio). This tangent is now the capital allocation line. All investments represented on this line are optimal (and will comprise of combination of the riskfree asset and risky 17 stock portfolio).
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The Steps
We will implement the procedure in three steps: 1. For each asset (and for the time period that you have chosen), calculate the mean return, volatility and the correlation matrix. 2. Set up the spreadsheet so that the Solver can be used. See the sample spreadsheet. Your objective here is to determine the weights of the portfolio that will allow you to achieve a specified required rate of return with the lowest possible volatility. 3. Repeat 2 for a range of returns, and plot the frontier (return vs. volatility).
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Step 2: (4/4)
Finally, you specify the arguments that need to be optimized. In this case, you are searching for the optimal weights, so you will have to specify the range in the spreadsheet where the portfolio weights used [A20, A21, A22].
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Step 3
The final step is to simply repeat step 2, until you have a sufficiently large data set so that the minimum variance frontier can be plotted.
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Diversification (1/6)
We have observed that by combining stocks into portfolios, we can create an asset with a better risk-return tradeoff. The reduction of risk in a portfolio occurs because of diversification. By combining different assets into a portfolio, we can diversify risk and reduce the overall volatility of the portfolio. Let us review the factors that affect how risk can be diversified. Here we will ignore the issue of allocation (as we have already considered it), and instead assume that our portfolio is equally 29 weighted.
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(3/6)
To examine the effect of correlation and the number of assets, lets assume, for simplicity, that each of the assets have the same volatility (say, 40%) and the same average correlation with each other. The portfolio volatility can then be calculated by the usual formula, and we can examine the reduction in volatility of the portfolio as we change the number of assets, or the correlation.
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N 1 3 5 10 20 30 40 50 100000
Port Vol 40.00% 34.25% 32.98% 32.00% 31.50% 31.33% 31.24% 31.19% 30.98%
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In Summary (1/2)
1. The optimal allocation is determined in two steps. First, we decide the allocation between the risky portfolio, and the riskless asset. Second, we determine the allocation between the assets that comprise the risky portfolio. 2. As every portfolio of the risky assets and the riskless asset has the same Sharpe ratio, there is not one optimal portfolio for all investors. Instead, the allocation will be determined by individual-specific factors like risk aversion and the objectives of the investor, taking into account factors like the investors horizon, wealth, etc. 3. When we are considering the allocation between different classes of risky assets, it is possible to create a portfolio that has the highest Sharpe Ratio. The weights of the risky assets in this portfolio will determine the optimal allocation between various risky assets. This portfolio can be determined graphically by drawing the capital allocation line (CAL) such that it is tangent to the minimum variance frontier. This portfolio will always lie on the upper part of the frontier (or on the efficient part of the frontier).
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In Summary (2/2)
4. The extent to which you can decrease the volatility of the portfolio depends also on the correlation. The lower the average correlation of the stocks in your portfolio, the lower you can decrease the volatility of your portfolio. 5. The homework provides you with an exercise to determine the optimal allocations.
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