The State of South Carolina
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From Exhibit 1 estimated average return for common stock 12.96% which is highest but this high return is associated with high volatility of 20.32% which increases the investors risk. Investing in the portfolio shown in Exhibit 1 will help Richard to better off in two ways high excepted return with lower volatility.
Thus investing solely in treasury bills, bonds and corporate bonds is not good idea as from the table below you can see that by choosing efficient portfolio with common stock in it raises our return above treasury bills, bonds and corporate bonds provides with low volatility.
The Sharp ratio tells us whether a portfolios returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk.
Solving using risk solver (Exhibit 2), I recommend investing in following portfolio
Treasury Bills
Treasury Bonds
Corporate Bonds
Common Stocks
Sharpe Ratio
Sharp ratio for Treasury Bonds, Corporate Bonds and Common Stocks is
Treasury Bonds
Corporate Bonds
Common Stocks
Sharp Ratio
We can see that sharp ratio of portfolio and that of common stock is same but when we compare volatility of both it is less for our portfolio compared to common stock. The optimal portfolio to combine with the risk free asset will be the one with the highest sharpe ratio, where the line with the risk free investment just touches and so is tangent to the efficient frontier of risky investment. The portfolio that generates this tangent line is known as the tangent portfolio. Thus in our case portfolio with sharpe ratio of 0.44 generates tangent portfolio and all other portfolio of risky assets lie below it.
2) Diversification is one of the two methods to reduce investment risk. Diversification relies on the lack of tight positive relationship among the assets return and works when correlation are near zero or somewhat positive. In our case from correlation between equity and bond market shows quite low level of correlation between some of the largest market. Thus true benefit of global diversification arises from the fact that the returns of different stock market and bond market around the world are not perfectly positively correlated. (Exhibit 3)
The international diversified portfolio opportunity set shifts leftward of the purely domestic opportunity portfolio set, the investor can find a portfolio of lower expected risk for each level of expected return or for each level of expected risk he can find higher level of expected return using international diversified