Using the Weighted Sum of Dependent Gaussians Formula

for Markowitz Portfolio Optimization

Expected returns E(r )

Standard deviation of returns stdev
Variance of returns
Relative weighting, where w(1) + w(2) = 1

R - Correlation
-0.35

expected r
stdev
variance
weighed combinations W(1), W(2)
\
ependent Gaussians Formula

Stock A Stock B
10.00% 12.00%
8.30% 9.50%
0.00689 0.00903
0.25 0.75

Covariance = R*StDev(1)*StDev(2) = Formula for Variance of Weighted Sum

-0.00276 0.00447

Stock A Stock B
10.00% 12.00%
8.30% 9.50%
0.006889 0.009025
0 1
0.1 0.9
0.2 0.8
0.3 0.7
0.4 0.6
0.5 0.5
0.6 0.4
0.7 0.3
0.8 0.2
0.9 0.1
1 0
W(1) W(2)
 Risk-free rate
1%

Portfolio Portfolio Sharpe Ratio

Standard Deviation Expected Return 1.57
6.7% 11.5% Sharpe Ratio = (portfolio expected Return minu

covariance combined combined

(same for all weightings) variance formula standard deviation

-0.0028 0.0090 9.50%

-0.0028 0.0069 8.30%
-0.0028 0.0052 7.19%
-0.0028 0.0039 6.23%
-0.0028 0.0030 5.50%
-0.0028 0.0026 5.10%
-0.0028 0.0026 5.10%
-0.0028 0.0030 5.50%
-0.0028 0.0039 6.23%
-0.0028 0.0052 7.19%
-0.0028 0.0069 8.30%
0%
 Highest possible Sharpe ratio equals the slope of the Capital Market Line

tio = (portfolio expected Return minus risk-free rate of return) / (portfolio standard deviation)

expected return against expected volatility Capital Market Line

12.00% 0.20
11.80% 0.17
11.60% 0.15
11.40% 0.13
11.20% 0.12
11.00% 0.11
10.80% 0.11
10.60% 0.12
10.40% 0.13
10.20% 0.15
10.00% 0.17
0.01
 Performance of Weighted Portfolios
and the Capital Market Line
20.00%
19.00%
18.00%
17.00%
16.00%
15.00%
14.00%
13.00%
12.00%
expected r
11.00% Capital Ma
10.00%
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%

Note: The line with greatest Slope (highest Sharpe ratio) connecting the risk-free rate point on the Y ax
and a tangent point on the curve of expected returns against volatility of returns at different weightin
(shown in blue) is called the "Capital Market Line" (shown in red).
ed Portfolios
Line

expected return against expected volatility

Capital Market Line

9.00% 10.00%

e risk-free rate point on the Y axis

of returns at different weightings