Markov's trilemma

3 asset allocation model

CORRELATION
Asset weights exp return std .dev Sharpe ratio GM
GM 0.333333 21.30% 37.60% 0.38 GM 1
MRK 0.333333 41.30% 30.10% 1.14 MRK 0.12
GE 0.333333 41.00% 24.00% 1.42 GE 0.26
1
0.333333 0.333333 0.333333
COVARIANCE
Risk free rate 7% GM
Expected return 34.53% GM 0.141376
variance 0.045223 MRK 0.013581
Exp st dev 21.27% GE 0.023462
Sharpe 1.294728
CORRELATION
MRK GE
0.12 0.26
1 0.3
0.3 1

COVARIANCE
MRK GE
0.013581 0.023462
0.090601 0.021672
0.021672 0.0576
 Markov's trilemma
3 asset allocation model
CORRELATION
Asset weights exp return std .dev Sharpe ratio GM
GM 0 21.30% 37.60% 0.38 GM 1
MRK 0.346438 41.30% 30.10% 1.14 MRK 0.12
GE 0.653562 41.00% 24.00% 1.42 GE 0.26
1
0 0.346438 0.653562
COVARIANCE
Risk free rate 7% GM
Expected return 41.10% GM 0.141376
variance 0.045291 MRK 0.013581
Exp st dev 21.28% GE 0.023462
Sharpe 1.602498
CORRELATION
MRK GE
0.12 0.26
1 0.3
0.3 1

COVARIANCE
MRK GE
0.013581 0.023462
0.090601 0.021672
0.021672 0.0576
 Markov's trilemma
3 asset allocation model
CORRELATION
Asset weights exp return std .dev Sharpe ratio Gm
GM -0.008004 21.30% 37.60% 0.38 Gm 1
MRK 0.348443 41.30% 30.10% 1.14 MRK 0.12
GE 0.659561 41.00% 24.00% 1.42 GE 0.26
1
-0.008004 0.348443 0.659561
COVARIANCE
Risk free rate 7% Gm
Expected return 41.26% Gm 0.141376
variance 0.045704 MRK 0.013581
Exp st dev 0.213785 GE 0.023462
Sharpe 1.602646

The Sharpe ratio will not change significantly because the amount of shorting of the GM stock is very little.
 CORRELATION
MRK GE
0.12 0.26
1 0.3
0.3 1

COVARIANCE
MRK GE
0.013581 0.023462
0.090601 0.021672
0.021672 0.0576

he GM stock is very little.

 Markov's trilemma
3 asset allocation model
CORRELATION
Asset weights exp return std .dev Sharpe ratio GM
GM -0.613597 21.30% 37.60% 0.38 GM 1
MRK 0.213352 41.30% 30.10% 1.14 MRK 0.12
GE 1.400245 41.00% 24.00% 1.42 GE 0.8
1
-0.613597 0.213352 1.400245
COVARIANCE
Risk free rate 7% GM
Expected return 53.15% GM 0.141376
variance 0.055628 MRK 0.013581
Exp st dev 0.235856 GE 0.072192
Sharpe 1.956782

The GM returns are lower for high std. dev as compared to other stocks and therefore, including GM in the por
The best option to maximize the sharpe ratio is to short the GM stock and buy more of GE as GE returns are hig
The positive correlation between the securities can be exploited to increase the sharpe ratio only if the shorting
 CORRELATION
MRK GE
0.12 0.8
1 0.3
0.3 1

COVARIANCE
MRK GE
0.013581 0.072192
0.090601 0.021672
0.021672 0.0576

efore, including GM in the portfolio and going long will lower the sharpe ratio.
re of GE as GE returns are higher for lesser risk.
harpe ratio only if the shorting is allowed in the portfolio
 Markov's trilemma
3 asset allocation model
CORRELATION
Asset weights exp return std .dev Sharpe ratio GM
GM 0.408906 21.30% 37.60% 0.38 GM 1
MRK -0.131178 41.30% 30.10% 1.14 MRK 0.12
GE 0.722273 41.00% 24.00% 1.42 GE -0.8
1
0.408906 -0.131178 0.722273
COVARIANCE
Risk free rate 7% GM
Expected return 32.91% GM 0.141376
variance 0.00704 MRK 0.013581
Exp st dev 8.39% GE -0.072192
Sharpe 3.087443

The sharpe ratio has increased significantly because of the -ve correlation between the GE and GM stocks.
The -ve correlation between the stocks has reduced the overall risk in the portfolio and therefore the std dev. T
 CORRELATION
MRK GE
0.12 -0.8
1 0.3
0.3 1

COVARIANCE
MRK GE
0.013581 -0.072192
0.090601 0.021672
0.021672 0.0576

n the GE and GM stocks.

o and therefore the std dev. This led to an increase in the sharpe ratio.
 Markov's trilemma
3 asset allocation model
CORRELATION
Asset weights exp return std .dev Sharpe ratio GM
GM 0.077475 21.30% 37.60% 0.38 GM 1
MRK 0.643009 41.30% 30.10% 1.14 MRK 0.12
GE 0.279515 30.00% 30.00% 0.77 GE 0.26
1
0.077475 0.643009 0.279515
COVARIANCE
Risk free rate 7% GM
Expected return 36.59% GM 0.141376
variance 0.057701 MRK 0.013581
Exp st dev 0.240211 GE 0.029328
Sharpe 1.231915

The sharpe ratio has fallen.

The MRK weight in the portfolio will increase as the stock returns are higher for same risk when compared to th
Again, the weight of GM is very low as the stock returns are lower with higher risk.
CORRELATION
MRK GE
0.12 0.26
1 0.3
0.3 1

COVARIANCE
MRK GE
0.013581 0.029328
0.090601 0.02709
0.02709 0.09

me risk when compared to the GE stock.

 Markov's trilemma
3 asset allocation model
CORRELATION
Asset weights exp return std .dev Sharpe ratio GM
GM 0 21.30% 37.60% 0.38 GM 1
MRK 0.346438 41.30% 30.10% 1.14 MRK 0.12
GE 0.653562 41.00% 24.00% 1.42 GE 0.26
1
0 0.346438 0.653562
COVARIANCE
Risk free rate 7% GM
Expected return 41.10% GM 0.141376
variance 0.045291 MRK 0.013581
Exp st dev 21.28% GE 0.023462
Sharpe 1.602498

If no shorting is allowed, the investor will not include GM in its portfolio as it will induce lesser returns for highe
The portfolio's sharpe ratio will have no change as compared to the base case
 CORRELATION
MRK GE
0.12 0.26
1 0.3
0.3 1

COVARIANCE
MRK GE
0.013581 0.023462
0.090601 0.021672
0.021672 0.0576

nduce lesser returns for higher risk in the portfolio.

 Markov's trilemma
3 asset allocation model
CORRELATION
Asset weights exp return std .dev Sharpe ratio GM
GM 0 21.30% 37.60% 0.38 GM 1
MRK 0.346438 41.30% 30.10% 1.14 MRK 0.12
GE 0.653562 41.00% 24.00% 1.42 GE 0.8
1
0 0.346438 0.653562
COVARIANCE
Risk free rate 7% GM
Expected return 41.10% GM 0.141376
variance 0.045291 MRK 0.013581
Exp st dev 21.28% GE 0.072192
Sharpe 1.602498

Even if the correlation between GM and GE increases to 0.8, the Sharpe ratio will not increase as the investor w
As discussed earlier, positive correlation between the securities can be leveraged only if one of the security is sh
 CORRELATION
MRK GE
0.12 0.8
1 0.3
0.3 1

COVARIANCE
MRK GE
0.013581 0.072192
0.090601 0.021672
0.021672 0.0576

not increase as the investor will not include GM in his portfolio without shorting.
only if one of the security is shorted.
 Markov's trilemma
3 asset allocation model
CORRELATION
Asset weights exp return std .dev Sharpe ratio GM
GM 0.359558 21.30% 37.60% 0.38 GM 1
MRK 0 41.30% 30.10% 1.14 MRK 0.12
GE 0.640442 41.00% 24.00% 1.42 GE -0.8
1
0.359558 0 0.640442
COVARIANCE
Risk free rate 7% GM
Expected return 33.92% GM 0.141376
variance 0.008655 MRK 0.013581
Exp st dev 9.30% GE -0.072192
Sharpe 2.893308

In this case, the high -ve correlation between the GM and GE securities can be used effectively to reduce the ris
As a result, Sharpe ratio will increase as the risk in the portfolio is reduced as a result of diversification.
 CORRELATION
MRK GE
0.12 -0.8
1 0.3
0.3 1

COVARIANCE
MRK GE
0.013581 -0.072192
0.090601 0.021672
0.021672 0.0576

d effectively to reduce the risk in the portfolio.

ult of diversification.
 Markov's trilemma
3 asset allocation model
CORRELATION
Asset weights exp return std .dev Sharpe ratio GM
GM 0.052357 21.30% 37.60% 0.38 GM 1
MRK 0.447644 41.30% 30.10% 1.14 MRK 0.12
GE 0.5 41.00% 24.00% 1.42 GE 0.26
1.000001
0.052357 0.447644 0.5
COVARIANCE
Risk free rate 7% GM
Expected return 40.10% GM 0.141376
variance 0.044509 MRK 0.013581
Exp st dev 21.10% GE 0.023462
Sharpe 1.569069

The returns and sharpe ratio will get negatively affected because of the constraints.
Because the innvestor is not allowed to invest more than 50% in any one of the securities, he is bound to invest
As a result, the overall returns of the portfolio will be lower and the Sharpe ratio will fall.
 CORRELATION
MRK GE
0.12 0.26
1 0.3
0.3 1

COVARIANCE
MRK GE
0.013581 0.023462
0.090601 0.021672
0.021672 0.0576

curities, he is bound to invest some amount in other non-high return securities.

 Markov's trilemma
3 asset allocation model
CORRELATION
Asset weights exp return std .dev Sharpe ratio GM
GM 0.003085 21.30% 37.60% 0.43 GM 1
MRK 0.345455 41.30% 30.10% 1.21 MRK 0.12
GE 0.65146 41.00% 24.00% 1.50 GE 0.26
1
0.003085 0.345455 0.65146
COVARIANCE
Risk free rate 5% GM
Expected return 41.04% GM 0.141376
variance 0.045137 MRK 0.013581
Exp st dev 21.25% GE 0.023462
Sharpe 1.696499

The decrease in the Risk free rate has increased the sharpe ratio because the portfolio will earn higher returns t
The excess return over the risk free rate will lead to an increase in the Sharpe ratio.
This type of phenomenon is very rare in the world as the expected or required rates of return will also decline w
 CORRELATION
MRK GE
0.12 0.26
1 0.3
0.3 1

COVARIANCE
MRK GE
0.013581 0.023462
0.090601 0.021672
0.021672 0.0576

tfolio will earn higher returns than expected.

es of return will also decline with the decrease in the risk free rate.
 Markov's trilemma
3 asset allocation model
CORRELATION
Asset weights exp return std .dev Sharpe ratio INTEL
INTEL 0.302423 68.80% 43.80% 1.41 INTEL 1
MRK 0.105523 41.30% 30.10% 1.14 MRK 0.52
GE 0.592054 41.00% 24.00% 1.42 GE 0.2
1
0.302423 0.105523 0.592054
COVARIANCE
Risk free rate 7% INTEL
Expected return 49.44% INTEL 0.191844
variance 0.053357 MRK 0.068556
Exp st dev 23.10% GE 0.021024
Sharpe 1.837247
CORRELATION
MRK GE
0.52 0.2
1 0.3
0.3 1

COVARIANCE
MRK GE
0.068556 0.021024
0.090601 0.021672
0.021672 0.0576
 Markov's trilemma
3 asset allocation model
CORRELATION
Asset weights exp return std .dev Sharpe ratio INTEL
INTEL 0.302423 68.80% 43.80% 1.41 INTEL 1
MRK 0.105523 41.30% 30.10% 1.14 MRK 0.52
GE 0.592054 41.00% 24.00% 1.42 GE 0.2
1
0.302423 0.105523 0.592054
COVARIANCE
Risk free rate 7% INTEL
Expected return 49.44% INTEL 0.191844
variance 0.053357 MRK 0.068556
Exp st dev 23.10% GE 0.021024
Sharpe 1.837247
CORRELATION
MRK GE
0.52 0.2
1 0.3
0.3 1

COVARIANCE
MRK GE
0.068556 0.021024
0.090601 0.021672
0.021672 0.0576