Intermediate Investment Stock analysis project

Question

In this project we apply the portfolio theory and the CAP M model to solve the real world investment problems.

1. Analyze benefit of diversification
2. Construct Mean Variance Frontier
3. find the optimal risky portfolio for capital allocation
4. decompose risk and return of individual stocks using index model

Answer 1

Intermediate Investment Stock Analysis Project

In this project, we apply portfolio theory and the Capital Asset Pricing Model (CAPM) to address practical investment decisions and optimize portfolio performance.

1. Benefit of Diversification:
2. We begin by analyzing how diversification reduces unsystematic risk in a portfolio. By combining stocks with less than perfectly correlated returns, the overall portfolio risk decreases while maintaining or enhancing expected returns. This is demonstrated through a comparison of individual stock volatilities versus portfolio volatility.
3. Construction of the Mean-Variance Frontier:
4. Using historical return data and covariance estimates for the selected stocks, we construct the mean-variance frontier. This frontier illustrates the set of portfolios that offer the highest expected return for a given level of risk (standard deviation). It helps investors understand the trade-off between risk and return.
5. Finding the Optimal Risky Portfolio for Capital Allocation:
6. Applying the CAPM framework, we identify the optimal risky portfolio that maximizes the Sharpe ratio — the portfolio that offers the best risk-adjusted return. This portfolio serves as the basis for capital allocation decisions, combining the risky portfolio with a risk-free asset depending on investor risk tolerance.
7. Decomposition of Risk and Return Using the Index Model:
8. We apply the single-index (market) model to decompose each individual stock’s return and risk into systematic (market-related) and unsystematic (idiosyncratic) components. This helps in understanding the sources of risk and their impact on portfolio performance.

Overall, this project demonstrates the practical application of portfolio theory and CAPM in constructing efficient portfolios, managing risk, and optimizing returns.