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Risk And Return Tradeoff Memo Essay

1036 words - 4 pages

The process of portfolio construction can be quite complex. Analysts go through reams of statistics - past performance, future potential, and industry knowledge and rely on personal insights into the market to arrive at the final list (UOP, 2008). This memo will be based on the Constructing and Managing a Portfolio Simulation which details the fundamentals of portfolio construction in relation to the risk-return tradeoff and the relationship between investment strategy and investment performance. As a treasury analyst for Casa Bonita Ceramics, I was tasked to select the best stocks and allocate company resources to construct a portfolio. This memo will detail my decisions made in the simulation, discuss the Sharpe ratio and how it relates to investment decisions, and lastly, provide recommendations for changes in the organization's investment strategy in order to improve its investment performance.Simulation DecisionsFrom excess cash generated in 2004, the company decided to invest $800,000 in the stock market in which eight stocks had already been chosen. With the consideration of a high return without the risk of losing capital in mind, I narrowed it down to the final four stocks worth investing in: Desktop, Inc., Levinthal Defense Systems, Transconduit, Inc., and Goldstein and Delaney Bank. This was an astute stock selection and showed good judgment by diversifying the stock selection to reduce stock-specific risks.The next task was to allocate the $800,000 in a manner that maximized portfolio return and kept the portfolio risk below 22 percent. I chose to distribute the funds evenly between the four stocks which resulted in 20.45% portfolio risk, 12.74% portfolio return, and a Sharpe ratio of 38.46%. This was a good decision considering management would not approve of any risks above 22 percent which did not allow more funds to be allocated in stocks with higher returns and average risk. In addition, it was also wise to invest the entire amount in stocks; otherwise the unused amount would have only provided a return of 5 percent from bank deposits.A downturn in the economy required some investment changes to the portfolio. Management increased the portfolio risk to 30 percent and gave me the option to sell some of the stocks and invest up to $400,000 in government securities. In addition, an extra $400,000 could be borrowed for investing; however, a ceiling of $800,000 was set for each stock. I decided not to borrow any additional funds for investment given that the borrowing rate was at 8.80 percent and the average return rate was 8.50 percent. Although the market was risky at that point, the economy was not completely unstable so I did not invest in government securities since the stocks would still provide a higher return. The $800,000 was allocated as follows: $216,327 to Desktop, Inc., $175,939 to Levinthal Defense Systems, $144,000 to Transconduit, Inc., and $221,348 to Goldstein and Delaney Bank. The allocation resulted in an expected...

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