Portfolio Design: A Modern Approach to Asset Allocation

SOME NECESSARY TOOLS FOR ANALYSIS

Investments involve returns and risks. So it’s necessary to have a few tools to analyze each. This book will try to keep the mechanics as simple as possible. But an investment advisor has to have a few tools to do an effective job for a client. This section will list the tools briefly. An appendix will provide a description of each tool. Most of the tools are standard for any professional in the investment industry. But there is one measure, alpha*, which may be new to many readers.

First, the advisor needs measures of returns, of which three are important: the compound (or geometric) average, the arithmetic average, and the average real return. The real return is obtained by adjusting the nominal return for the inflation rate. The compound average should be used to measure long-run returns, while the arithmetic average is the best estimate of next year’s return and is used in many applications of modern portfolio management. Formulas for these averages are given in the appendix.

Second, the advisor needs measures of risk, two of which are the most important. The standard deviation is the standard measure of risk for financial assets. It reflects the total variability of an asset return. Beta measures only the variability that is systematically related to the market benchmark.

Third, the advisor needs measures of risk-adjusted returns. The Sharpe ratio measures the excess return on an asset (above the risk-free return) relative to the standard ...