Day 76 in MIT Sloan Fellows Class 2023, Managerial Finance7, Diversification and Sharp value
Asset returns are quite unpredictable and some assets are correlated each other. Investors look for portfolios that maximize their returns with the least amount of risk.
The main factors you need to consider when you build a portfolio are
- return
- risk - variance
- covariance - relationship with other components
How to find "the best portfolio"?
Fundamentally, it would be lower risk but higher return portfolio. However, there is no free lunch. Higher risk generate higher expected return.
But if you look at correlation carefully, then you can form low-risk portfolio with maintaining return.
Diversification merit limitation
However, diversification also can't minimize "market risk" which also called systematic risk or common risk.
For example,
- business cycle
- inflation
- volatility
- credit
- liquidity
- pandemic
Efficient flontier and Sharp value
Given an expected return, the portfolio that minimizes risk (measured by the standard
deviation or the variance) is a mean-variance frontier portfolio.
The upper part of the portfolio frontier gives the efficient frontier.
Then, the best balance between risk and return would be estimated by maximizing the slope of the line from risk-free asset as follows.
Sharp ratio is slope of capital market line between tangency portfolio point and risk-free asset(0, return)