Ratios Tell a Story

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Ratios Tell a Story

The first created portfolio is based on market capitalization weighted index which is also known as market value weighted index(Investopedia,2017).  The construction method of this portfolio refers to the weight of the total market value of each component in which larger companies have more significant influence on the portfolio performance(InvestingAnswers,2017). The efficiency of this market value based portfolio depends on whether all investors have the same information. Under the situation of information asymmetry, the stock price may easily be underpriced or overpriced which will confuse the weights in the portfolio. The other main drawback of this method is the index is heavily influenced by few corporations with enormous market capitalization. On the other hand, market portfolio is extremely easy to understand and calculate, it is also able to roughly reflects the change of market value for the chosen stocks (value Weight

Index,2016).

 Name Weight MMM 5.68% T 11.66% CAT 3.78% UTX 5.90% WFC 16.97% PFE 11.62% KO 12.26% ORCL 10.85% INTC 10.55% MRK 10.73% Total 100%
 Expected Return 1.23% Variance 0.05% Standard Deviation 2.20% Sharpe Ratio 0.53698

The second portfolio is called as passive management portfolio, which provides the optimal expected return for a given level of risk (The free dictionary, 2012). The portfolio is constructed according to Markowitz efficient portfolio theory which basically emphasized that risk is an inherent component of high return (Investopedia, 2017). The passive portfolio is capable of creating a relatively ideal combination of stocks which maximum possible expected return for a given level of risk. In addition, passively managed funds normally cost around 0.1% a year which is quite low compared to 0.75% of actively managed funds cost (Barclays, 2015). However, the Markowitz portfolio theory is mainly supported by two assumptions, the homogeneous expectations assumption, and the market efficient assumption. Firstly, the homogeneous expectations assumptions indicate that all investors have the similarity expectation to the inputs which are used to derive the asset return, variance, and covariance (The free dictionary, 2012). Secondly, the efficient market assumption can be specified into four components:1. A large number of investors trade securities for profit; 2. Stock prices adjust immediately to new information;3. Stock prices should reflect all available information; 4. New information comes to the market without restriction (Investopedia,2017).  Since not all assumptions can be fulfilled in reality, for example, the market may not be information efficient, the empirical result may be disparate from the theory.