magician

You can get zero volatility only if you have securities whose correlation of returns is -1; anything greater will leave some volatility.

If you create a zero-volatility portfolio its rate of return will be the risk-free rate, approximately that of 30-Year US Treasury Bonds; arbitrage will prevent you from earning a higher ROR.

If you're interested in determining the efficient frontier, take a look at my signature, 7 posts above.

cmflex84

I just did a project deriving efficient frontiers from hypothetical risky portfolios. The goal was to solve for portfolio weights that minimize the level of portfolio risk, given some level of expected return.

Magician: Do you do this for a living and if so how do you determine what securities an investor should hold in their optimal risky portfolio? I have a solid understanding of the concepts but actually choosing my own securities is challenging. Sometimes I feel like I am wasting my time trying to do this for myself and think that I should just buy a mutual or index fund to save time. After all I am still a student but I dont want to pay an advisor to do something that I could possibly do myself.

magician

Here's what I do for a living:

Teach mathematics at CSUF
Teach finance (review courses for the CFA exams), risk management, project management, and cash flow analysis at UCI.
Consult in project risk management: cost risk and schedule risk, primarily.
Develop software tools for finance and project management; our first tool - Portfolio Optimizer Pro (POP) - should be on the market in 2 - 3 weeks.
Entertain people with the impossible.

POP doesn't determine what securities an investor should hold, per se. We do not want to be in the business of recommending securities: too much downside risk. What POP does is help an investor determine an efficient allocation of their money amongst securities they've selected, based on historical risk, return, and correlation data. (A future version will remove the restriction of historical returns by allowing the user to include his estimate of future returns on any security.)

Aze85

for a portfolio to be properly diversified against idiosyncratic risk (standard deviation) you need between 30-50 stocks. this is something that many people cannot do, so that is what the mutual fund does. also, diversification requires investments in DIFFERENT industries, all across the board.

Aze85

[QUOTE=jwa4378,Dec 14 2006, 07:31 PM] Mutual funds are great, but if you know what you are doing, you can construct a no-risk portfolio based on the relationship of the stock prices in relation to known events.

magician

Thirty to fifty stocks is almost certainly too many. I analyzed a portfolio owned by an investment club that held 14 stocks: of those, 12 were sufficient to eliminate essentially all nonsystematic risk. What's surprising is that the members of the club never considered how their investments worked together in a portfolio: they ended up with a well-diversified portfolio by sheer serendipity.

"All across the board" is an overstatement.

What's worse is that many people - including the lion's share of investment advisors - seem to believe that having investments in many industries is sufficient to ensure diversification (i.e., the only type of diversification that matters in a portfolio: diversification of risk); in a nutshell: it isn't.

magician

That's where I come in: my job is to educate people on just that.

Constructing a near-zero risk portfolio is trivial: buy 30-Year US Treasuries. You'll earn the risk-free rate: no surprise.

If you have an efficient frontier constructed from the entirety of the market, there are no stocks beyond the frontier, by definition.

Aze85

i cannot remember which graph it is, but it shows how many stocks are required to diversify a portfolio. it shows the relation between the number of stocks and the risk of the portfolio. the risk starts to get close to the tangent line around 25 i believe. that is rather funny that they created a well diversified portfolio out of luck.
by "all across the board" i did not mean a stock in every industry, but that people try to create a portfolio that includes more than a few industries. investment in different industries is very important, but i never said it i was the fix all solution.

Aze85

Your right, investing in US Treasuries will yield low risk (i wasnt thinking), but it will also yield a low return. Interest rate risk is always present especially when your time to maturity is 30 years. of course you will not hold onto it until maturity.

regarding the efficient frontier you are right. by definition there will be no other stocks beyond the efficient frontir. but, there will be stocks beyond the efficient frontier since the market is not perfectly efficient. so it would be possible to make abnormal profits. however, finding these arbitrage oppurtunities is not easy. i think they require alot of fundamental analysis.

i am so burn t rout from exams. have been up for 30+ houson some addy. all i can remember from the last few days is corporate finance

you teach finance? that is awesome. i am an under grad student right now, gonna draguate really soon, hopefully.

please do correct me if i am wrong. this is a learning experince. i dont get to talk much finance except in classes and when studying for exams.