CHAPTER 9
Constructing Efficient Portfolios
In developing the basic model for equity valuation, we have necessarily touched on the valuation and volatility for both standard and inflation-protected debt securities. We have seen that each of the three asset classes shares both similarities and differences with the other two. Of particular relevance to us, equities are inflation resistant but do not have contractual real cash flows. Treasury Inflation Protected Securities, such as TIPS, are inflation resistant but do not share in the economic fortunes of equity securities. Traditional fixed-rate debt securities do not share in the economic fortunes of the firm but are not inflation resistant. These fundamental dissimilarities provide both opportunities and challenges to us as we attempt to form optimal portfolios.
The focus in this chapter is on allocation among these different asset classes. We assume that the tools for individual stock selection, as discussed in Chapters 4, 5, and 7, are already applied as a prerequisite. This analysis has two major features:
1. Our valuation models give us a robust way of specifying volatility and correlation structure for the three asset classes.
2. We can roughly infer reasonable expected return estimates among the different asset classes.
This second item is particularly relevant for common equity as an asset class because it typically has both the highest expected return and the greatest volatility among the asset classes.
Figures 9.1
