Optimum Portfolio

Today we will learn statistically how much weight we should give to one
asset in our portfolio.
Or How we can develop Optimum Portfolio.
Optimum Portfolio
Steps
1. Find excess return/Beta ratio for all assets in data
2. Rank all assets from highest to lowest Excess return/Beta ratio
3. Calculate Ci Cut off rate for each individual asset
4. Reach Optimum Cut off rate (C* ) for portfolio. Once this rate is
achieved stop adding more assets in portfolio and draw line here.
5. Calculate Zi for all assets you considered for portfolio
6. Find weight for each individual asset i.e Zi /∑Z
Optimum Portfolio
Let suppose RFR: 5

Assets Mean Excess Beta var Excess

return return return/
Beta
1 15 10 1 50 10
2 17 12 1.5 40 8
3 12 7 1 20 7
4 17 12 2 10 6
5 11 6 1 40 6
6 11 6 1.5 30 4
7 11 6 2 40 3
8 7 2 0.8 16 2.5
9 7 2 1 20 2
10 5.6 0.6 0.6 6 1.0
Optimum Portfolio
Calculating Cut off rate:
Suppose Varm=10

1 2 3 4 5 6 7

Assets Excess (excess Beta2/var ∑(R-Rf)β/var ∑Beta2/var Ci

return/Beta return)Beta/var
1 10 =(10)1/50=2/10 2/100 2/10 2/100 1.67

2 8 18/40= 4.5/10 5.625/100 6.5/10 7.625/100 3.69

3 7 3.5/10 5/100 10/10 12.625/100 4.42

4 6 24/10 40/100 34/10 52.625/100 5.43

5 6 1.5/10 2.5/100 35.5/10 55.125/100 5.45

6 4 3/10 7.5/100 38.5/10 62.625/100 5.30

7 3 3/10 10/100 41.5/10 72.625/100 5.02

8 2.5 1/10 4/100 42.5/10 76.625/100 4.91

9 2 1/10 5/100 43.5/10 81.625/100 4.75

10 1.0 0.6/10 6/100 44.1/10 87.625/100 4.52

Optimum Portfolio
• We calculated Ci by using this formula:
Varm(Column5)/ 1+ Varm(Column6).

This is how we calculate Ci for asset 1:

Now we put the values in above formula
10(2/10)/ 1+10(2/100)= 1.67
Optimum Portfolio
• Then we will set C*
• C* is the cut off rate: it is the maximum rate for which every investor
would like to go. In this problem C* is 5.45
• Now we can see that against this cut off rate C* there is asset 5. Here
we will stop and it means we will consider only first 5 assets. Thus rest
of the assets will be ignored for next calculations. draw a line here as
coloured area also show this in above slides.
Optimum Portfolio
• Once you find cut off rate i.e 5.45 in our example stop on this asset
for calculation of weights. It means all asset in yellow will be
considered for calculation of weights. It means till asset 5 we will
make investment.
Optimum Portfolio
Calculation of Z values and Sum of Zs.
• Zi = (Beta/ var) [ excess return to beta ratio- C*]
• Z1=(2/100)[10-5.45]= 0.091
• Z2=(3.75/100)[8-5.45]= 0.095625
• Z3=(5/100)[7-5.45]= 0.075
• Z4=(20/100)[6-5.45]= 0.110
• Z5=(2.5/100)[6-5.45]=0.01375
• Sum of Z=0.387875
Optimum Portfolio
Proportion of Investment in Assets.
• Proportion of investment in Asset 1= Z1/Sum of Zs
• 0.091/0.387875= 0.235 or 23.5%
• For Asset 2=24.6%
• Asset 3=20%
• Asset4= 28.4%
• Asset 5= 3.5%
• Total investment you cant make more than 100 percent