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Another Portfolio
Calculate the expected return and standard
deviation of the portfolio consisting of 80%
GE and 20% IBM
Diversification Benefit
The portfolio risk is lower than either of the
individual stocks
This is called the benefit of diversification
I repeat the above steps for other portfolio
weights, w=0, 0.1, 0.2, , 0.9, 1.0
I plot the expected return against standard
deviation
Portfolios of GE and IBM
$0 GE, $1000 IBM
$200 GE, $800 IBM
$400 GE, $600 IBM
$600 GE, $400 IBM
$800 GE, $200 IBM
$1,000 GE, $0 IBM
0.01
0.011
0.012
0.013
0.014
0.015
0.016
0.017
0.018
0.05 0.055 0.06 0.065 0.07 0.075 0.08 0.085 0.09 0.095
Expected Return
S
t
a
n
d
a
r
d
D
e
v
i
a
t
i
o
n
Investment Opportunity Set
13579
1
1
1
3
1
5
1
7
1
9
2
1
2
3
2
5
2
7
2
9
3
1
3
3
3
5
3
7
3
9
4
1
4
3
4
5
4
7
4
9
Variance
Number of Assets
Diversification and Risk
Systematic
Non-
Systematic
3
Feasible Portfolios
With N Risky Assets
Expected
Return E(R)
Std dev
Efficient
frontier
Investment Opportunity Set
or Feasible Set
A
B
C
Efficient Frontier
You can construct the efficient frontier using
one of two equivalent approaches.
For given expected return, find the
minimum variance
For given variance, find the maximum
expected return
You can do this using the Solver in Excel.
Utility Maximization
Expected
Return E(R)
Std dev
A
.
A is the Utility maximizing
risky-asset portfolio
Indifference Curves
B
C
Higher Utility
What if a risk-free asset is
available?
We have covered the capital allocation
problem between a risk-free asset and a risky
asset.
Recall that the capital allocation line is the
straight line through the risk-free asset and
the risky asset.
The Optimal Risky Portfolio
has the Highest Sharpe Ratio
Expected
Return E(R)
Std dev
Riskless
Asset
A
B
CAL
A
CAL
B
C
D
E