Portfolio Selection

Step 1:

Based on the assumption that young investor can tolerate more risk, I would recommend Portfolio 3 to him. It gives the highest average but comes with highest risk as well.

I would recommend Portfolio 4 to our 60 years old investor, assuming he’s more risk adverse because he’s retired. It gives the lowest volatility still a relative good return among the portfolios. However, in practice, you cannot invest in S&P 500 directly. So, I would recommend Portfolio 5 instead. It provides same return as portfolio 2 but provides additional diversification benefits (lower standard deviation).

Step 2:

The shape of the curve can be explained by correlation between two stocks.

The higher the correlation, the straighter the curve.

Less correlation provides a better diversification for portfolio.

[pic 1]

Two Assets: Harris and Urban. Correlation: 0.3

[pic 2]

Two Assets: Maya and Urban. Correlation: 0.23

[pic 3]

Two Assets: S&P 500 and equally weighted portfolio. Correlation: 0.61, this suggests this asset allocation method does not provide much diversification benefit compare to previous methods.

Step 3:

[pic 4]

0% Harris, 0% Urban and 100% Maya for 28 years old Investor. This portfolio has an expected return of 1.0788% and 12.57992%.

70% Harris, 20% Urban and 10% Maya for 65 years old retiree. This portfolio has an expected return of 0.6809% and 5.1592%.

S&P 500 Index locates above our three-stock portfolio, which means gives same return but less risky. This can be explained S&P 500 has more stocks than our portfolio, therefore, a lot of market risk has been diversified.