Portfolio Theory and the Capital Asset Pricing ModelCase Study: John and Marsha on Portfolio SelectionGROUP 3BATARA INDRA | MOHAMAD MASRUCHIN | YUDI CAHYADIPURA
The Mini Case:John:Wow! Potato futures hit their daily limit. Let’s add an order of gratin Dauphinoise. Did you manage to hedge the forward interest rate on that euro loan?
The Mini Case:John:Yes, I’m using a market risk premium of 7.5% and the risk-free interest rate is about 5%. That gives 12.5%. But Pioneer’s beta is only 0.65. I was going to buy 30,000 shares this morning, but I lost my nerve. I’ve got to stay diversified. Marsha:Have you tried modern portfolio theory?John:MPT? Not practical. Looks great in textbooks, where they show efficient frontiers with 5 or 10 stocks. But I choose from hundreds, maybe thousands, of stocks. Where do I get the inputs for 1,000 stocks? That’s a million variances and co variances!Marsha:Actually only about 500,000, dear. The co variances above the diagonal are the same as the co variances below. But you are right, most of the estimates would be out-of-date or just garbage.John:To say nothing about the expected returns: Garbage in, garbage out.Marsha:But John, you don’t need to solve for 1,000 portfolio weights. You only need a handful. Here’s the trick: Take your benchmark, the S&P 500, as security 1. That’s what you would end up with as an indexer. Then consider a few securities you really know something about. Pioneer could be security 2, for example. Global, security 3. And so on.