Portfolio Diversification Manage Risk Effectively Single Assets vs

Portfolio Diversification Manage Risk Effectively

Single Assets vs. Diversified Portfolios Single Asset Diversified Portfolio Simple Complicated construction Easy to calculate returns Returns are weighted to assets in portfolio Good for speculation (risky) Minimizes risk for a given expected return

The Efficient Frontier • An optimal mix of assets within a portfolio allows for higher returns for a given level of risk • Alternately, the optimal allocation of assets in the portfolio provides for the lowest level of risk needed to satisfy a given expected return. • There exists one portfolio where the risk/reward ratio (Sharpe ratio) is maximized.

Overlapping Efficient Frontier and Individual Asset Risk/Reward • Notice how the outermost portfolios form a sort of curve. • This is the efficient frontier. Many more portfolios exist on this curve. • We can see that investing solely in AAPL, whose risk is about 1. 65% the expected daily return is about. 083%. • If we look towards the efficient frontier curve, we can see that there should be a portfolio with 1. 65% risk that has an expected daily return of about 0. 125%. This is much more desirable. 0, 25 0, 2 0, 15 0, 1 AAPL 0, 05 0 0 0, 5 1 1, 5 2 2, 5 3 3, 5 4

The Optimal Portfolio • With the risk level of 1. 65% from the previous slide, we can devise a portfolio that maximizes the expected return. • This portfolio will consist of 11. 30% allocated towards AAPL, 15. 44% to GOOG, 36. 54% allocated to TSLA, and 36. 73% to DIS. Its expected return is 0. 13%, much higher than the 0. 09% shown by the single asset portfolio. • When we think of the ‘optimal portfolio’, we want the highest reward/risk ratio. This loosely means that reward will outweigh risk by a certain amount. • In order to maximize this ratio, we will optimize the portfolio again, and deliver the final result: MSFT AAPL GOOG TSLA DIS 10% 17. 5% 16. 7% 38. 8%

Optimized Readout

Closing Remarks • Each investor’s optimal portfolio will be different based on their risk profile, however we can use tools such as portfolio optimization workbooks to ensure that any portfolio will be built such that the asset allocation of said portfolio will result in a risk-reward ratio that lies on the efficient frontier. • For access to the portfolio optimization file I used in this program, please visit my personal website: http: //academicanalyst. weebly. com