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Portfolio Diversification and Risk

A job at East Coast Yachts, Part 2

You are discusing your 401K with Dan Ervin, when he mentions that Sarah Brown, a representative from Bledsoe Financial Services is visitng East Coast Yachts today. You decide that you should meet with Sarah, so Dan sets up an appoinment for you later in the day.
When you sit down with Sarah, she discusses the various investment options availabel in the company's 401K account. You mention to Sarah that you researched East Coast Yachts before you accepted your new job. You are confident in management's ability to lead the company. Analysis of the company has led to your belief that the company is growing and will achieve a greater market share in the future. You also feel you should support your employer. Given these considerations, along with the fact that you are a conservative investor, you are leaning toward investing 100% of your 401K account in East Coast Yachts.
Assume the risk-free rate is the historical average risk-free rate. The correlation between the bond fund and the large cap stock fund is .16.

1) Considering the effects of diversification, how should Sarah respond to the suggestion that you invest 100% of your 401K account in East Coast Yachts?
2) After hearing Sarah's response to investing your 401K account entirely in East Coast Yachts stock, she has convinced you that this may not be the best alternative. Since you are a conservative investor, you tell Sarah that a 100% investment in the bond fund may be the best alternative, Is it?
3) Using the returns for the Bledsoe Large-Cap Stock Fund and the Bledsoe Bond Fund, graph the opportunity set if feasible portfolios.
4) After examining the opportunity set, you notice that can invest in portfolio consisting of the bond fund and the large-cap stock fund that will have exactly the same standard deviation as the bond fund. This portfolio will also have a greater expected return. What are the portfolio weights and expected return of this portfolio?
5) Examining the opportunity set, notice there is a portfolio that has the lowest standar deviation. This is the minimum variance portfolio. What are the portfolio weights, expected return, and standard deviation of this portfolio? Why is the minimum variance portfolio important?
6) A measure of risk-adjusted performance that is often used is the Sharpe ratio. The Sharpe ratio is calculated as the risk premium of an asset divided by its standard deviation. The portfolio with the highest possible Sharpe ratio on the opportunity set is called the Sharpe optimal portfolio. What are portfolio weights, expected return, and standard deviation of the Sharpe optima portfolio? How does the Sharpe ratio of this portfolio compare to the Sharpe ratio of the bond fund and the large-cap stock fund? Do you see a connection between the Sharpe optimal portfolio and the CAPM? What is the connection?

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Solution Summary

This solution illustrates and discusses the effect of portfolio diversification on the risk inherent in a portfolio of mutual funds.