CONSTRUCTING AN OPTIMAL PORTFOLIO USING

SHARPE’S SINGLE INDEX MODEL

This article is based on the construction of portfolio in the Indian stock market with the help of
the model named Sharpe Single Index Model.. We decide the percentage of investment of every
single stock is decided on the weights which are assigned to all stock on its respective beta
value, stock movement variance unsystematic risk, return on stock and risk free return vis-à-vis
the cut off rate of return.

Markowitz Model had serious practical limitations due the rigors involved in compiling the
expected returns, standard deviation, variance, covariance of each security to every other
security in the portfolio. Sharpe Model has simplified this process by relating the return in a
security to a single Market index. The basic preposition of the Sharpe Index Model (SIM) is that
the return on a security could be regarded as linearly related to single index of the market. The
idea is that all stocks are affected by the movement in the share market. When market moves up
prices of most of the shares tend to increase. And, in case, when market moves down, the prices
of most of the stocks tend to decline. However, the prices of all the shares may not move at the
same time. The sensitivity of a security price to a change in market may be different for different
securities. As the model has been presented by Sharpe, this model is also known as Single Index
Model.

The single index model is based on the assumption that stocks vary together because of the
common movement in the stock market and there are no effects beyond the market that
account the stocks co- movement. The expected return, standard deviation and co-variance of
the single index model represent the joint movement of securities.

𝐑𝐢 = 𝛂𝐢 + 𝛃𝐢𝐑𝐦 + 𝐞𝐢

Where,

Ri – expected return on security

αi - intercept of the straight line or alpha co-efficient

βi- slope of straight line or beta co-efficient

Rm- the rate of return on market index

ei- error term

The variance of the security has two components namely, systematic risk or market risk and
unsystematic risk or unique risk. The variance explained by the index is referred to systematic
risk. The unexplained variance is called residual variance or unsystematic risk.

Systematic Risk = βi ^2 * Variance of market index

= βi^ 2 * σ^2m

Unsystematic Risk = Total variance – Systematic Risk

Ei^ 2 =σi _ Systematic Risk

Thus, Total Risk = Systematic Risk + Unsystematic Risk

= βi ^2 * σ2m + ei^ 2

From this, the portfolio variance can be derived

𝛔 𝒑 𝟐 = ∑𝐗𝐢𝛃𝐢 𝟐 𝛔 𝟐𝐦 + ∑𝐗𝐢 𝟐𝛔 𝟐𝐞𝐢

σ2 p= Variance of Portfolio

σ2 =Expected Variance of Index

ei 2= Variation in Security’s return not related to the market index

Xi = the portion of stock i in the portfolio

Single index model has been criticized because of its assumption that stock prices move
together only because of common co-movement with the market. Many researchers have found
that there are influences beyond the market, like industry-related factors, that cause securities to
move together. Empirical evidence, however, reveal that the more complex models have not
been able to consistently outperform the single index model in terms of their ability to predict
ex-ante co-variances between stock returns.

Sharpe had provided model for the selection of appropriate securities in a portfolio. The
selection of any stock is directly related to its excess return-beta ratio. .

(Ri – Rf)/ βi

Where,

Ri = the expected return on stock

Rf = the return on a riskless asset

βi = the expected change in the rate of return on stock i associated with one unit change in the
market return.

After determining the securities to be selected, the portfolio manager should find out how much
should be invested in each security. The percentage of funds to be invested in each security can
be estimated as follows.

X1 =______Zi______
N ∑i = 1 Zi

Zi = βi [(Ri – Rf)/ βi − C ∗]

The first expression indicates the weights on each security and they sum up to one. The second
shows the relative investment in each security. The residual variance or the unsystematic risk has
a role in determining the amount to be invested in each security.

An investor can choose the securities for his/her portfolio very easily with the help of
Single Index Model. He/she can select the best securities for the portfolio which helps to
make high returns with minimum risk.