Nhung Nguyen

BUS 172B
Project 1
11/15/15

6 assets chosen: S&P 500, IA Small Stock, IA All Value, GS Commodity, IA Monthly
Convertible Bond, and S&P/IFCG Emerging Composite.

1. CML equation:
r r
r xr f pm m x
pm

13.97 3
r x3
12.47 x

1097
r x3
1247 x

The composition of the market portfolios (PM):

Optimal combination of
Assets risky assets in tangent
portfolio
S&P 500 34.37%
IA Small Stock 24.94%
IA All Value 8.05%
GS Commodity 30.63%
IA Monthly Convertible Bond 8.55%
S&P/IFCG Emerging Composite -6.54%

PORTFOLIO WEIGHTS IN AN OPTIMAL (TANGENT) PORTFOLIO

40.00%

30.00%

20.00%
PORTFOLIO WEIGHTS
10.00%

0.00%
1 2 3 4 5 6
-10.00%
ASSET NUMBER
There is a negative weight for S&P Emerging Composite. This is a short position, which means
the investor is going to borrow money to purchase this asset and put it up as a collateral to
achieve an optimal return of 13.97%.
The role of these 6 assets is to achieve an average return while spreading out and minimizing the
overall risk of all assets through diversification.

2. The point on the CML I would choose is a point to the right of the optimal point of the PM
that gives a return of 16% with a standard deviation of 14.78%. That means, I would have
118.5% on the market portfolios and short -18.5% on the risk-free assets.

1097
r x3
1247 x

1097
16% = 3
1247 x

x 14.78

r xrf
The weight of the portfolio is calculated using the following formula: w
r pmr f
16 3
w 118.5
13.97 3
The weight for the risk free asset:
1w1118.5 18.5

r pmr m
3. Sharpe ratios equation: S
pm

13.97 3
Market Portfolios: SPM = 0.880
12.47

16 3
Personal Portfolio: Sp = 0.880
14.78

The Sharpe ratios are the same because they are the slopes of the CML.

4. Identify 2 new points on CML with risks 3% lower and higher than personal optimal point.

To calculate new standard deviation: add or subtract 3% from the standard deviation of the
personal optimal point. To calculate the new return, use the following equation: rx = rf + Sp *
x

Risk 3% lower Personal portfolio Risk 3% higher

Return 13.36% 16.00% 18.64%
Standard deviation 11.78% 14.78% 17.78%
The weights for these new portfolios can be calculate using the formulas in part 2.

Risk 3% lower Personal portfolio Risk 3% higher

Weight of PM 94.5% 118.5% 142.6%
Weight of risk free assets 5.5% -18.5% -42.6%

Sharpe ratios stay at 0.8796. Therefore, they would not influence me to reconsider my personal
optimal point.

5. 3 assets chosen: S&P 500, S&P Emerging Composite, IA Convertible Bond

Assets OPTIMAL COMBINATION OF RISKY ASSETS IN

TANGENT PORTFOLIO
S&P 500 39.74%
S&P Emerging Composite 0.68%
IA Convertible Bond 59.58%

PORTFOLIO WEIGHTS IN AN OPTIMAL (TANGENT) PORTFOLIO

80.00%
60.00%
40.00%
PORTFOLIO WEIGHTS
20.00%
0.00%
1 2 3
ASSET NUMBER

The Sharpe ratio for this portfolio is 0.7078. The optimal return is 12.98% with a standard
deviation of 14.10%.

The 3 asset portfolio is inferior compared to the 6 asset portfolio because it is less diversified. It
has lower Sharpe ratio and lower optimal return while the risk is higher.

6. Second highest return: S&P 500 14.72%.

a. Increase return by 2%:

Optimal combination of risky assets
Assets
in tangent portfolio
S&P 500 225.70%
IA Small Stock 79.42%
IA All Value -155.80%
GS Commodity 48.87%
IA Monthly Convertible Bond -97.93%
S&P/IFCG Emerging Composite -0.26%
 b. Decrease risk by 2%

Optimal combination of risky

Assets
assets in tangent portfolio
S&P 500 158.82%
IA Small Stock 52.45%
IA All Value -89.78%
GS Commodity 35.79%
IA Monthly Convertible Bond -55.63%
S&P/IFCG Emerging Composite -1.66%

PORTFOLIO WEIGHTS IN AN OPTIMAL (TANGENT) PORTFOLIO

200.00%
150.00%
100.00%
50.00%
PORTFOLIO WEIGHTS
0.00%
-50.00% 1 2 3 4 5 6
-100.00%
-150.00%
ASSET NUMBER

c.
Increase return Reduce risk of
of 2nd highest 2nd highest
Original return asset by return asset by
portfolio 2% 2%
Return 13.97% 21.71% 16.00%
Standard
Deviation 12.47% 17.97% 13.21%
Sharpe ratio 0.8797 1.0412 0.9841
d. Increasing return on one asset while keeping other inputs constant sharply increase the
return, standard deviation, and also Sharpe ratio of the portfolio. Reducing the risk of one
asset while keeping other inputs constant also increase the return, standard deviation, and
Sharpe ratio but not by a lot compared to increasing the return. Therefore, the outcomes
tend to be more sensitive when the return of an asset is increase as opposed to reducing
the standard deviation by the same amount of change.

7. Forecasting is an integral part in the optimization process. Investors should focus on the return
and the risk/standard deviation and how sensitive they are to changes. Assets with higher
standard deviation fluctuate more when the market is good and usually generate higher returns.
The Sharpe Ratio indicates the risk-adjusted return, the average return in excess of the risk free
rate over the total risk. A more diversified portfolio would generate a higher Sharpe ratio.
Therefore, investors should pay detailed attention in choosing the individual assets. Another
factor that needs to be focused on is the long term economic environment predictions and
analysis of the operating conditions of the corporations. Finally, the risk of the investment plan
should be aligned with the investors risk tolerance.

8. The optimal portfolio should be a point located on the CML with a return and risk that match
the investors risk tolerance. As a moderate investor, my optimal point should be the market
portfolio optimal point generated by the Excel or the point that is slightly to the right of that
market portfolio. Each individual asset should be chosen so that it could contribute to the overall
diversification of the portfolio. As a moderate risk tolerant investor, I would choose a 60/40 or
70/30 stocks to bonds ratio. The correlations of the assets affect the overall risk and return of the
portfolio. It is best to choose stocks that are not closely correlated to each other for higher
diversification effect. Short positions are highly recommended as it would give investors a
choice to broaden their portfolios, thus increasing the return while reducing the overall risk.