The objective of any effective asset allocation strategy is
the generation of maximum desirable return with the acceptable level of risk.
However more often than not coming with up with a strategy
which proves to be successful in every conceivable scenario proves to be an
impossible riddle to solve. Various theories and models have been put forward
in the last few decades which have tried to answer that riddle.
Arguably Foremost amongst these theories were those
forwarded by Nobel Laureate Harry Markowitz in 1952. At a time when finance was
nothing more than ”rule of thumbs, accounting manipulations and analysis of
discounted value” (Merton, 1990), Markowitz developed what now known as modern
portfolio theory in which the desirability of maximizing portfolio return was
an important assumption along with the undesirability of taking risk by the
investor. He tried to explore the problem of maximizing the return of a
portfolio at a given level of risk (Varian, 1993). During this process
Markowitz came up with the concept of efficient frontier which according to him
was a set of portfolios, consisting of risky assets, offering the highest
possible returns for any level of risks or vice versa. This concept proved to
be his most important contribution and perhaps the genesis of the modern
In this report in order to satisfy the requirements put
forward by the assignment questions, an attempt has been made to develop (using
MS excel) efficient frontiers of a portfolio consisting of seven stocks namely Tesco Plc (TSCO) Barclays
Plc (BARC) British American Tobacco (BAT) British Petroleum (BP) Pfizer Inc. (PFE) Microsoft Inc. (MSFT) and Caterpillar Inc.
(CAT). The rationale behind the selection of these stocks was that each of
these stocks represents different industries with no apparent significant
relationship with each other. The stocks represent the convenience stores,
financial services, Tobacco, Oil and Gas, pharmaceuticals, IT and Industrial
goods industries. The reason behind choosing stocks from seven different
industries was to observe first-hand the diversification benefit that effective
asset allocation is said to provide to the investor.
The efficient frontiers have been graphed for a total of
three scenarios. The presence of a risk less asset offering a risk free rate of
return has also been incorporated for one of the scenarios while short selling
has been allowed for the other two scenarios. The expected returns are
calculated by a capital asset pricing model (CAPM) and Market Model Approach.
Initially the mean annual returns, variance and standard
deviations of the chosen stocks and the index (FTSE 100) were calculated using the
monthly returns representing the period of five years from September 2012 to 2017.
The returns of the stocks were then regressed against the index to calculate
the beta of the chosen stocks. The beta was also calculate The alphas were
calculated using the INTERCEPT function in excel