Finance concepts and applications

Finance

The portfolio I constructed consists of Google and Apple. The rationale for this seemingly simple portfolio is actually quite complex. The portfolio maximizes my long-run wealth, and this paper will explain how this will work. The bottom line for me is that no other portfolio was going to deliver the same benefits as a 50/50 portfolio of these two technology giants.

Description of the Portfolio

Portfolio theory holds that a diversified portfolio will perform in line with the market on a risk-adjusted basis. This means that when a portfolio is fully diversified it will have a beta of pretty close to 1.0. But the thing about understanding this portfolio theory is that you have to take into account a wide range of factors in constructing the optimal portfolio. This paper will in part walk through this process of constructing this very dynamic portfolio that will deliver me superior returns.

It has been noted that there are a few critical elements to modern portfolio theory. The first of these is security valuation, then there is asset allocation, portfolio optimization and performance measurement (Investopedia, 2014) so these are all factors that went into my portfolio selections. The first is the security valuation. What this means is that every security has a price. So you have to know the price of the security, and also you need to figure out whether that is a good price or a bad price. This calculation is based primarily on where you want the stock to go in the future. If you think the stock is going to go up, you buy and if you think the stock is going to go down, you do not buy. It's that simple.

In this case, we had Apple and Google, which are two of the most valuable stocks. These companies both have a lot of cash on their balance sheets, which means that they are quite valuable, and also they earn a lot of money as well. The result of this is that their stocks reflect a high level of earnings in the past, and also that people in the market think that these earnings will continue in the future. This is quite a reasonable understanding because these are two technology giants that dominate the mobile business, and mobile is a large and growing business. There is no reason to think that these two companies cannot continue to grow like they have, with billions in profits every year. So obviously if you want a valuable portfolio you need the two most valuable companies in that portfolio, and that is the direction in which I was leading.

The second thing is the asset allocation. The Securities Exchange Commission (SEC) has a guide that helps you explain asset allocation. It says that there are two things you need to take into consideration when figuring out your asset allocation (SEC, 2014). So the first thing is the time horizon. The general rule of thumb is that the longer the time horizon the more risk you should have in your portfolio. If the entire market collapses tomorrow, you still have a lot of time left to make that back before you die. So there's that. I have a long time horizon, which means that I should have mostly equities in my portfolio, but of course you want companies that don't go down when the market goes down. If you look at Apple and Google, these companies really didn't go down when everybody else did in 2009, so they are basically recession-proof companies that don't go down. When the stock drops for a while, history shows that it will go back up, so that is time to buy.

The other thing with asset allocation is risk tolerance. Some people cannot handle risk, and as a result of that they maybe should have a lower percentage of equities in their portfolio. If the proverbial market collapsed tomorrow scenario was to occur, people with a low risk tolerance would have a myocardial infarction, while people with a high risk tolerance would barely look up from the poker table to take note of the situation. So for me, I am one of those people with a fairly high risk tolerance. I am young, and I do not need the money any time soon because this is my retirement fund. That points to a portfolio that has all equity, except maybe if I am making monthly contributions and there is some cash sitting there waiting to be invested. But otherwise all equity makes sense with a very long time horizon and high risk tolerance.

The third thing you have to think about when choosing a portfolio is portfolio optimization. With this, you just want to have a portfolio that makes as much money as possible given a specific risk level. For me, I have set the risk level pretty high -- I am willing to take on extra risk in order to get returns. Except that with Google and Apple it isn't really risk because they make billions every year, and those income streams seem to be pretty reliable. But you realize that if strong form efficient market hypothesis holds, that the portfolio is expected to perform in line with its risk characteristics (Beggs, 2014). So you create a portfolio that has higher risk, if you want your portfolio to enjoy greater success. This portfolio has a high risk portfolio, designed to optimize returns. Apple has a beta of 0.93 and Google has a beta of 1.14. The result is the portfolio beta is 1.035, so it is not all that risky after all.

Performance measurement is another key thing to think about. The big thing with performance measurement is that it has to be on a risk-adjusted return capacity. So the key here is that if the market moves 100%, as a baseline, then the portfolio should move 103.5%, because this portfolio is just slightly riskier than a generic market portfolio. As a consequence of this, there is a means to measure the portfolio because the expected performance is known, and the actual performance can be measured against the expected performance in this situation. That is how the portfolio is measured with respect to whether it outperformed or maybe if it underperformed instead.

The idea of going 50/50 was a good idea to start -- it is hard to choose which one of these companies is better. But the SEC also cautions against not rebalancing. The SEC defines rebalancing as when you "bring your portfolio back to the original asset allocation mix" (SEC, 2014). Right now, that probably is not important, but over time if one company starts to really outperform the other one, then the issue of rebalancing will need to be considered, because they are supposed to be 50/50 in the portfolio, but when the price changes this portfolio can become unbalanced. But being unbalanced also affects the returns, making them less predictable that when the portfolio does have a lot of balance.

All of this means that there are many considerations that need to be taken into account with the asset allocation. As a young person with a long time horizon and a low risk tolerance I definitely feel that all equity is the way to go, and I want top performing companies. The portfolio altogether has a beta of 1.035 so it is not actually that much riskier than just having an index fund in there. So I feel that this portfolio accurately reflects my investment needs at this time, and thus is a great portfolio to have constructed on the basis of this careful analysis of the many different factors that go into asset allocation.

Performance

Apple and Google were purchased on April 1st. The following chart illustrates the performance on this portfolio:

Start

Finish

Return

Apple

13.38%

Google

94.90%

Portfolio

82525

116683

41.39%

S&P 500

1900.53

0.80%

The expected performance was 1.035 * 0.80%, or .0.828%. Based on the risk characteristics of the portfolio -- the weighted average of the two betas, the value of my original portfolio should be around $85,413, with the initial starting value of $82, 525. The actual portfolio value is $116,683, which is a heck of a lot higher than the expected value. So it would seem that my strategy paid off. Not only did I earn a pretty darn good nominal return on the investment portfolio, but on a risk-adjusted basis this portfolio dramatically outperformed the market.

There are reasons for this. While Apple did well, it is evident that Google did better than well during this period. Google stock split right after I bought it. What this means is simple -- there were twice as many shares but their value was cut in half. Except that's not quite what happened. As often happens, the stock rallied after the split. The reason is simple. Google was a very expensive stock, but after the split more people could afford to buy into the company (Anderson, 2014). The result of this is that the lower price brought in a lot of demand for Google stock that had previously been sitting on the sidelines. The company increased immediately after the split and maintained the high level subsequent to the split, an encouraging sign. Either the market is valuing Google right now, or the company was undervalued prior to the split.

It is also worth noting that Apple also outperformed the market as well. Apple is expected to move even less than the S&P, which barely budged over this period, but Apple was up 13%. Apple popped after it announced a stock split of its own later in April, having noticed the value that the split gave to Google shareholders. Just the announcement of the split caused Apple stock to go up, and the split has not even happened yet (Dilger, 2014).

It should be noted that this performance is really abnormal, because stock splits are sporadic, unusual events. They can drive a stock to increase, as what happened here with the two components of this portfolio, but they do happen once in a while, and in particular with companies that are highly successful like these two. That is why you go for value and buy stock in companies that are very successful and valuable -- good things happen when you play on a winning team.

Sharpe's Measure

There are a number of different ways to evaluate the performance of a portfolio. Sharpe's measure is one such way. The Sharpe ratio is basically the same thing as evaluating the portfolio on a risk-adjusted basis, as was done above. So the formula for the Sharpe ratio is as follows:

(source: Investopedia)

The inputs here are the expected return, which is the return on the market, so Sharpe:

.08 * 1.035 = 0.828%. The risk free rate for a month is 0.01, so the expected return is 0.818%, divided by the 1.035, to get a total of 0.79%. This is the expected return. The actual return was 41.39%, which is just a wee bit higher. So on the whole, the portfolio dramatically outperformed the market, and outperformed the level to which it was expected to perform on a risk-adjusted basis. The result is that this portfolio enjoyed stellar performance -- of course the problem is that it was based on a one-off event and is not likely to be replicated any time soon. This is a real shame, because the portfolio sure did well over the past couple of months.

Treynor's Measure

Another way to evaluate the performance of a portfolio is with Treynor's Measure. This is calculated as the average return of the portfolio -- average return of the risk free rate / beta of the portfolio. When we input the data from the portfolio performance, the following is what results:

.4139 - .01 / 1.035 = 0.39%

This ratio again shows that the portfolio outperformed its risk-adjusted benchmark quite considerably. This is what you want to see. These measures, the Sharpe and the Treynor, are quite similar, in that they outline what the expected return of the portfolio really ought to be under normal circumstances. These, of course as noted, were not normal circumstances and the portfolio dramatically outperformed on a risk-adjusted basis.

Jensen's Measure

Jensen's Measure is another way of looking at risk-adjusted returns, which is the proper way to evaluate a portfolio. What Jensen's measure is based on is the capital asset pricing model. The CAPM predicts the return of the portfolio, based on its risk. So CAPM would have predicted the following performance over the past two months, using Jensen's measure, assuming the 7% market risk premium:

J = 41.39 -- (.01 + (1.035 ( 7 ))

J = 34.135

The rule of thumb here is that the higher the Jensen alpha, the more the portfolio has outperformed the market. So what has happened here is that the portfolio has outperformed the market by a lot, something that the other ratios and data confirm as well. This tells me that the portfolio was quite well-designed.

Soundness

On the basis of this performance, the portfolio was rather sound. When evaluating the soundness of a portfolio, there are a couple of different factors that need to be taken into consideration. The first such factor is whether the objectives of the portfolio were met. I would say that this happened. Basically, the portfolio was constructed with two of the largest most profitable companies to exist since the dawn of time. The idea was simple -- investing in the best companies will provide superior returns. It was not predicted that the portfolio would outperform in the way that it did, but the portfolio was clearly oriented towards outperforming. So the objective of beating the market on a risk-adjusted basis was very much met. The other objective is a long time investment for retirement, and with that I figure adding $34k to the portfolio in a couple of months is pretty good. I would probably take some of those profits, too, as part of the rebalancing process.