Term Paper: Finance the Portfolio I Constructed

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[. . .] 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.

On a risk vs. return portfolio, the performance of this portfolio has been well-established throughout this report. It is important to keep in mind, however that there principles for investing like EMH and asset allocation are designed to work when there is a large data set. The portfolio is expected to perform in line with the market, risk-adjusted, on average. So this means over the long run. Over the short run, anything is possible. This performance was exceptional, but it is also known what the prevailing exceptional circumstances were for this performance. Thus, nobody expects this portfolio to duplicate such stellar performance; that was actually more than just a little bit lucky. But over the long run, it is reasonable to think that companies with a strong track record of dominating their industries are going to outperform, even when other companies have similar betas, that does not mean that those companies are poised to continue with their success.

Overall, I think the runaway success does provide a market lesson. Imagine for a minute that instead of the price going way up on the portfolio, that it went way down. This would be incredibly distressing for most investors, but for an investor willing to take on this portfolio the expectation is that there might be some ups and downs, because even though the portfolio beta is 1.035, it is not actually all that diversified, with only two securities in it, and both companies being in approximately the same industry. The reality is that this portfolio had a fluke hit, and might never duplicate that performance, so the exercise really doesn't say much about long-term investment strategy. As an investor, I have to simply not worry about such short-term moves, good or bad, because crazy things sometimes happen in the market. I should not come away from this thinking that I am an investment god, or that I can just make money with these two companies.

The reality is that investing is fairly complex, and there are a number of variables. Over a two-month span, it is extremely difficult to get a read on a portfolio, but the portfolio that is best is one that will outperform on a risk-adjusted basis, using these different ratios like Sharpe, Jensen and Treynor, and will continue to outperform in the long run based on being a well-run company. Outperformance in the short run is okay, certainly nobody is going to complain about it, but such outperformance should also be recognized for what it is, the happy outcome of a one-time event, that gives the portfolio a head start but that is about all it does. The long run performance is still going to be 1.035 times the market with these two companies, even if they just happened to have a great month.

So in essence, I really would not have changed much of anything in this portfolio -- given the performance I think that in hindsight the entire class would buy my portfolio -- but going forward I still like the looks of these two companies to outperform the market on a risk adjusted basis because of their innovative capabilities, corpulent balance sheets and leading market positions. Those are the kinds of companies I like to invest in.

References

Anderson, K. (2014). Why Googl is up following Google stock split. Money Morning. Retrieved May 27, 2014 from http://moneymorning.com/2014/04/03/why-googl-is-up-following-google-stock-split/

Beggs, J. (2014). The efficient market hypothesis. About.com. Retrieved May 26, 2014 from http://economics.about.com/od/Financial-Markets-Category/a/The-Efficient-Markets-Hypothesis.htm

Dilger, D. (2014). Why Apple decided to split its stock… [END OF PREVIEW]

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Finance the Portfolio I Constructed.  (2014, May 27).  Retrieved April 21, 2019, from https://www.essaytown.com/subjects/paper/finance-portfolio-constructed/8525755

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"Finance the Portfolio I Constructed."  Essaytown.com.  May 27, 2014.  Accessed April 21, 2019.
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