Investment Portfolio Exercise Term Paper

Excerpt from Term Paper :


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.


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












S&P 500



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,…

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