OPTIMAL PORTFOLIOS &

EFFICIENT FRONTIERS

WORKING PAPER

By

Malcolm Athaide

September 25, 2010

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ABSTRACT

This study focuses on the background and relationship of asset pricing, optimal portfolios and
efficient portfolio frontiers. This has been discussed in light of multiple crisis; right from the Asian
Crisis of 1997, dotcom of 2001 till the financial crisis of 2008. This study tracks the changes in
asset portfolio frontiers based on changes in asset prices in the background of a business cycle. By
applying the portfolio model for an efficient frontier, the paper shows that efficient portfolios are
ones where asset pricing is done with a tactical approach. The efficient portfolio contribution to
asset allocation over cycles uses equity prices to validate the study. The results were obtained,
assuming asset returns to be independent and multivariate normally distributed.

Key words

Asset Pricing, Efficient Frontiers, Optimal Portfolios

BACKGROUND

Efficient Market Hypothesis (EMH) was first expressed by French mathematician Louis
Bachelier (1900) and emerged as a prominent theory in the 1960s when Bachelier’s work
began to circulate among contemporary academics. Eugene Fama is generally given
credit as the father of modern EMH as his work provided evidence for the hypothesis,
while he extended and refined the theory. An efficient market is a market that is efficient
in processing information. In an efficient market, prices ‘fully reflect’ available
information (Fama 1970). Fama classified EMH into three forms of efficiency: weak,
strong and semi-strong. The three forms of EMH are commonly distinguished:

Strong form EMH

Market prices incorporate all information, both publicly available and also that available
only to insiders. If the strong form of the EMH holds, then insider trading is ineffective,
in the sense that its application should not enable investors to obtain higher investment
returns through information that is known only to themselves and not to the general
public.

Semi-strong form EMH

Market prices incorporate all publicly available information. If the semi-strong form of
the EMH holds, then fundamental analysis based upon such information should not be
able to generate higher investment returns for the investor. Fundamental analysis uses
information concerning the issuer of the security (e.g. turnover, profitability, liquidity,
level of gearing) and general economic and investment conditions (e.g. real interest rates
and inflation) in order to determine the “true” or “fundamental” value of a security and
hence whether or not it is cheap or dear.

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Weak form EMH

The market price of an investment incorporates all information contained in the price
history of that investment. If the weak of the EMH holds, then trading rules based only on
historical price data should not be able to generate higher investment returns for the
investor. Such trading rules form the basis of technical analysis. Studies on market
efficiency suggest that the weak and the strong form efficiency hold but there is
significant debate about the semi-strong form efficiency.

LITERATURE REVIEW

In the 1960s and early 1970s, the controversy focused on the extent to which successive
changes in prices of the stocks were independent of each other or whether stock prices
followed a random walk. The early tests to answer this question were conducted by Fama
(1965) and Samuelson (1965), in which they concluded that most of the evidence seems
to have been consistent with the efficient market hypothesis (EMH). Stock prices
followed a random walk model and the predictable variations in equity returns, if any,
were found to be statistically insignificant. Other studies in the US with similar findings
included those of Sharpe (1966), Friend et al. (1970), and Williamson (1972).

Throughout the 1980s, EMH has provided the theoretical basis for much of the research,
and most empirical studies during these years focused on predicting prices from historical
data, while also attempting to produce forecasts based on variables such as P/E ratios
(Campbell and Shiller 1987), dividend yield (Fama and French 1989) and term structure
variables (Harvey 1991)

Efficiency of Equity Markets

Efficiency of equity markets has important implications for the investment policy of the
investors. If the equity market in question is efficient researching to find miss-priced
assets will be a waste of time. In an efficient market, prices of the assets will reflect
markets best estimate for the risk and expected return of the asset, taking into account
what is known about the asset at the time. Therefore, there will be no undervalued assets
offering higher than expected return or overvalued assets offering lower than the expected
return. All assets will be appropriately priced in the market offering optimal reward to
risk. Hence, in an efficient market an optimal investment strategy will be to concentrate
on risk and return characteristics of the asset and/or portfolio. However, if the markets
were not efficient, an investor will be better off trying to spot winners and losers in the
market and correct identification of miss-priced assets will enhance the overall
performance of the portfolio Rutterford (1993). EMH has a twofold function - as a
theoretical and predictive model of the operations of the financial markets and as a tool in
an impression management campaign to persuade more people to invest their savings in
the stock market (Will 2006).

The efficiency of stock markets is one of the most controversial and well studied
propositions in the literature. Even if there have been a number of researches and journal
articles, economists have not yet reached a consensus about whether capital markets are
efficient or not. The wide range of studies concerning the efficient market hypothesis in
the literature provides mixed evidences. The studies by Prusty (2007) supports the weak
form efficiency of Indian capital market. There have been some studies (Gupta and Basu
2007; Mishra 2009; Mishra and Pradhan 2009) which do not support the existence of
weak form efficiency in Indian capital market.

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Price Expectations

The EMH for the equity market is a statement about the theory that equity prices reflect
the true value of stocks; the absence of arbitrage opportunities in an economy populated
by rational, profit-maximizing agents; and the hypothesis that market prices always fully
reflect available information (Fama 1970). In Jensen (1978), an efficient market is
defined with respect to an information set  t if it is impossible to earn economic profits
by trading on the basis of  t . Fama (1970) presented a general notation describing how
investors generate price expectations for stocks. This could be explained as (Cuthbertson
1996):
E ( p j ,t 1 |  t )  [1  E (r j ,t 1 |  t )] p jt (1)
where E is the expected value operator, p j ,t 1 is the price of security j at time t+1, r j ,t 1
is the return on security j during period t+1, and  t is the set of information available to
investors at time t.The left-hand side of the formula E ( p j ,t 1 |  t ) denotes the expected
end-of-period price on stock j, given the information available at the beginning of the
period  t . On the right-hand side, 1  E (r j ,t 1 |  t ) denotes the expected return over the
forthcoming time period of stocks having the same amount of risk as stock j.
Under the efficient market hypothesis (EMH), investors cannot earn abnormal profits on
the available information set  t other than by chance. The level of over value or under
value of a particular stock is defined as:
x j ,t 1  p j ,t 1  E ( p j ,t 1 |  t ) (2)
where x j ,t 1 indicates the extent to which the actual price for security j at the end of the
period differs from the price expected by investors based on the information available
 t . As a result, in an efficient market it must be true that:
E ( x j ,t 1 |  t )  0 (3)
This implies that the information is always impounded in stock prices. Therefore the
rational expectations of the returns for a particular stock according to the EMH may be
represented as:
Pt 1  E t Pt 1  ε t 1 (4)
where Pt is the stock price; and  t 1 is the forecast error. Pt 1  E t Pt 1 should therefore
be zero on average and should be uncorrelated with any information  t . Also
E ( x j ,t 1 |  t )  0 when the random variable (good or bad news), the expected value of
the forecast error is zero:
E t  t 1  E t ( Pt 1  E t Pt 1 )  E t Pt 1  E t Pt 1  0 (5)

Tests for EMH

Tests of the EMH fall under three major categories, tests for random walk in asset prices,
event studies and performance of professional investors. All these tests compare observed
asset returns against returns predicted by the EMH, controlling for systematic risk. One
first need to understand what any assets normal returns should look like; based upon its
level of risk. Therefore, tests of the EMH are joint tests of market efficiency and the asset
pricing model (e.g. the CAPM or APT) used to estimate systematic risk.

Tests of the Weak Form EMH

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Tests for serial correlation are often used to test the weak form EMH. Positive serial
correlation: above (below) normal returns are followed by subsequent above (below)
normal returns, otherwise referred to as momentum. Negative serial correlation: above
(below) normal returns are followed by subsequent below (above) normal returns,
otherwise referred to as reversals in returns.

Tests of Semi-strong Form Efficiency

Event studies look at stock price reaction to new information released to the public.
Delayed responses or overreaction to new public information implies a violation of the
semi-strong form EMH. There is a little mixed empirical evidence from event studies, but
efficiency is generally supported. In addition, the problem of jointly testing the
underlying asset pricing model and market efficiency is still unresolved, i.e., first one
needs to know what the normal returns should look like before any inference can be made
concerning market efficiency.

Current State of EMH

Despite the many advances in the statistical analysis, databases, and theoretical models
surrounding the EMH, the main result of all of these studies is to harden the resolve of the
proponents of each side of the debate. Are stock prices too volatile because markets are
inefficient, or due to risk aversion, or dividend smoothing? All three inferences are
consistent with the data. Moreover, new statistical tests designed to distinguish among
them will no doubt require auxiliary hypotheses of their own which, in turn, may be
questioned. More importantly, tests of the EMH may not be the most informative means
of gauging the efficiency of a given market. The Efficient Market Hypothesis is based on
a simple assumption that risk is defined by volatility. According to the theory, investors
are risk adverse: they are willing to accept more risk for higher payoffs and will accept
lower returns for a less volatile investment. It has always been assumed that volatility is
risk which may not be always true.

The premises of the concept of efficient market are:

 Investors are rational, thus they show adversity to risk and want assets that give
maximum output for minimum risk;
 Current rates show all the available information;
 Outputs are independent, unlinked at different moments in time with an
approximately normal distribution;
 Markets are “random walk” type.

In reality, the premises listed above are not real: investors don’t always show aversion to
risk, they don’t react promptly to information, their guided by trend (built on past
information) in present strategies. Because of this, the premises that investors are rational,
rate modification is independent and markets are “random walk” can’t be accepted. The
irregular assimilation of information, as it is in reality, can lead to the tendency of random
movement- “biased random walk”, named fractal time series. On the reverse side, the
hypothesis of random movement is supported by the following aspects:
 The distribution of outputs isn’t perfectly normal;
 The risk of some extreme events is greater than the one supposed by the theory of
efficient markets;
 The output has the same distribution regardless of the horizon of time chosen;
 Volatility rises with a greater rate than T but after a sufficient period of time it
drops suddenly.

During the 1970s and 1980s, assessment of the EMH was largely confined to econometric
studies. The process of financial deregulation, beginning with the breakdown of the
5

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Breton Woods system in the early 1970s was a gradual one. It was only by the mid-1980s
that most restrictions on international capital flows and exchange rate movements were
completely removed. The end of domestic deregulation took even longer. So, it was not
until the 1990s till 2008 that failures of the global financial system could reasonably be
regarded as evidence against the EMH.

The evidence of financial crisis was not long in coming. A number of developing
countries experienced severe financial crises in the 1990s, even though their governments
had done their best to follow the policy prescriptions of economic liberalism, in particular
by deregulating financial markets and encouraging private investment. The experience of
the US itself provided plenty of evidence against the EMH. The near-collapse and
government-orchestrated rescue of hedge fund LTCM provided a preview of the massive
bailouts of 2008 and 2009, undermining some key assumptions of the EMH in the
process. Even more significantly, the boom and bust in the shares of ‘dotcom’ companies
that promised to generate vast profits from the Internet showed that all the sophistication
and complexity of modern financial markets only served to make possible bigger and
better bubbles.

Asian economies had enjoyed decades of strong growth through policies of export-
oriented industrialisation, rejecting the ‘import replacement’ policies, aimed at economic
self-sufficiency that had been tried and failed elsewhere. From the early 1990s onwards,
they had been engaged in a process of financial deregulation. The Asian financial crisis
cast doubt on the idea that globalization was both inevitable and beneficent, as did the
failure of Washington consensus policies in Argentina. In the dotcom asset bubble,
previous bubbles might have been dismissed on the basis that the markets concerned
weren’t fully informed and transparent, or that speculators were prevented from betting
against the bubble assets and thereby bringing prices back to earth. Although the dotcom
bubble and bust was spectacular, the 2000-01 crash was at least equally significant for the
exposure of corporate fraud on a scale unparalleled (at the time) since the 1920s. The two
biggest frauds, Enron and WorldCom offered a sharp contrast. The Enron frauds relied on
a complex network of trading schemes, special purpose vehicles and elaborate accounting
devices. By contrast, the managers of WorldCom simply invented revenue numbers that
made the company look massively profitable when it was actually losing money hand
over fist.

OPTIMAL PORTFOLIOS

Over the last 50 years, Markowitz' modern portfolio theory (Markowitz 1952) has
become one of the cornerstones of finance theory and is still the most important guide to
constructing portfolios with an optimal trade-off between risk and return. Classical mean
variance optimization, in Markowitz' theory, assumes that an investor will always choose
a portfolio with maximum expected future return given a specific level of portfolio risk,
measured as portfolio variance or standard deviation. Often, the portfolio optimization
algorithm is subject to further constraints like short-selling restrictions or maximum
allocations to a single asset class. Uncertainty about future asset returns is taken into
account by assuming that the asset returns are drawn randomly from a normal
distribution, where the mean and standard deviation are known as well as the paired
correlations between different assets. It is this uncertainty about future returns that
compels us not to put all our eggs in one basket. If one knew future returns exactly, it
would suffice to invest in the single asset with the highest positive future return. But since
one does not know the best performing asset in advance, mean variance optimization
shows us how to allocate our wealth to different assets in order to maximize future return
expectations.

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The Capital Asset Pricing Model (CAPM) is centred on the Security Market Line (SML),
on which the financial assets are located. Also important is the Capital Market Line,
which is obtained by investing a proportion of the resources in the market portfolio and
another proportion in a risk-free asset, such that the returns from this new asset are the
weighted returns of the proportion of each individual asset. Black (1972) demonstrated
that the CAPM model is met even without the existence of a risk-free asset; this asset is
defined as having β= 0. In a model, the market portfolio is also defined as a portfolio that
is a risky asset with β = 1 (Jarrow 1988). CAPM requires risk-free assets (β = 0) and
assets from the market portfolio (β =1).

Portfolio Optimisations

According to the CAPM theory, a portfolio that lies in the efficient frontier and combined
with certain proportion of risk free investment, and given a desired risk level, maximizes
the return of the combined portfolio. This definition is valid even if the desired risk level
is less than the minimum defined by the efficient frontier. Given the risk free rate of
return, how to determine the optimal risky portfolio? That optimal risky portfolio is just
the point of tangency between the Capital Market Line and the efficient frontier. As this
optimal portfolio has to lie along the efficient frontier; the point of tangency is located at
the line with the maximum tangent between that line and the horizontal line. It is not
necessary to generate indifference curves or even the efficient frontier given the
Separation Theorem posited by Tobin. According to the CAPM theory, the investor will
prefer a position in the “market portfolio” either levered or unlevered. Then, the optimal
portfolio is given by this optimization problem (Vélez-Pareja 2001)

s.t. (6)

where i is the weight of stock i in the portfolio, is the covariance between stocks k
and j, Rm is the portfolio return, r is the risk-free rate of return and m is the number of
stocks in the analysis. The restriction that the s be positive might be included. In that
case there is no short position. This can be seen in the next figure

Fig I: Capital Market Line, Efficient Frontier and Optimal Portfolio

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The solution to his optimization problem produces the j‘s and hence the optimal
portfolio return. Done this, the investor will select the desired risk level combining the
optimal portfolio with an appropriate portion of risk free investment.

Asset Allocation

The figure below shows the efficient frontier which is a set of risk and return for the
portfolio at different combination of the assets. This hyperbola is called the opportunity
set as it represents all the possibilities, however only the upper half above the minimum
variance point represents the efficient set as it gives the maximum return for a given risk.

Fig II: Efficient frontier for asset portfolio

According to CAPM(Capital asset pricing model), the maximum return for any investor
can be obtained by a combination of the risky portfolio represented by the efficient
frontier and the risk free portfolio which are the Government bonds.The capital market
line which represents the different combinations will be a tangent to the efficient frontier
as it gives the investor the maximum utility.Selection of these proportions will depend on
the risk aversion of the investor.

For a risk averse investor his portfolio will lie on the line which is a tangent to the
efficient frontier on the left side half of the tangency point whereas in the case of a risk
taking investor this will lie on the right half which suggests that a risk taking investor will
borrow at the risk free rate and invest in the risk portfolio. It is found that the risky
portfolio giving the maximum portfolio return is the market portfolio consisting of all
risky assets in proportions of their market capitalizations.

Most asset allocation analyses use the mean-variance approach for analyzing the trade-off
between risk and expected return. Analysts use quadratic programming to find optimal
asset mixes and the characteristics of the capital asset pricing model to determine
reasonable optimization inputs (Sharpe 2007).

Many institutional investors periodically adopt an asset allocation policy that specifies
target percentages of value for each of several asset classes. Typically, a policy is set by
the fund manager within a specified range around the policy target level. Most asset
allocation studies include at least some analyses that use standard mean-variance
optimization procedures and incorporate at least some of the aspects of equilibrium asset-
pricing theory based on mean-variance assumptions— typically, a standard version of the

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capital asset pricing model, possibly augmented by assumptions about asset mispricing.
In a complete asset allocation study, a portfolio manager typically does the following:
 Selects desired asset classes and representative benchmark indices.
 Chooses a representative historical period and obtains returns for the asset
classes.
 Computes historical asset average returns, standard deviations and correlations.
 Estimates future expected returns, standard deviations, and correlations.
Historical data are typically used, with possible modifications, for standard
deviations and correlations.
 Find several mean-variance-efficient asset mixes for alternative levels of risk
tolerance.
 Projects future outcomes for the selected asset mixes.
 Presents to the investor the relevant summary measures of future outcomes for
each of the selected asset mixes.

Mean-Variance Analysis

Much of modern investment theory and practice builds on the Markowitz (1952)
assumption that an investor need be concerned in many cases solely with the mean and
variance of the probability distribution of his or her portfolio return over a specified
future period. Given this assumption, only portfolios that provide the maximum mean
(expected) return for given variance of return warrant consideration. One can hence
consider a representative set of such mean-variance-efficient portfolios of asset classes in
an asset allocation study and choose the one that best meets the investor’s preferences in
terms of the range of relevant future outcomes over one or more future periods.

A focus on only the mean and variance of portfolio return can be justified in one of three
ways. First, if all relevant probability distributions have the same form, mean and
variance may be sufficient statistics to identify the full distribution of returns for a
portfolio. Second, if an investor wishes to maximize the expected utility of portfolio
return and considers utility a quadratic function of portfolio return, only mean-variance-
efficient portfolios need be considered. Thirdly, over the range of probability distributions
to be evaluated; a quadratic approximation to an investor's true utility function may
provide asset allocations that supply expected utility adequately close to that associated
with a fully optimal allocation (Levy and Markowitz 1979).

Asset allocation studies often explicitly assume that all security and portfolio returns are
distributed normally over a single period (for example, a year). If this were the case, the
focus on mean-variance analysis would be appropriate, no matter what the form of the
investor's utility function. But there is increasing agreement that at least some return
distributions are not normally distributed, even over relatively short periods, and that
explicit attention needs to be given to "tail risk" arising from greater probabilities of
extreme outcomes than those associated with normal distributions. In comparison
quadratic utility functions are characterized by a satiation level of return beyond which
the investor prefers less return to more—an implausible characterization of the
preferences of most investors. To be sure, such functions have a great analytical
advantage and may serve as reasonable approximations for some investors' true utility
functions. Although mean-variance analysis may provide a sufficient approximation in a
given setting to produce an adequate asset allocation, it would seem prudent to evaluate
the efficacy of the traditional approach by at least conducting an alternative analysis
based on detailed estimates of possible future returns and the best possible representation
of the investor's preferences. Given such a set of forecasts, one can show below how an
optimal portfolio would be chosen if one used a traditional mean-variance analysis; then,
present the more general approach that can take into account an alternative form of an

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investor's utility function. Subsequently, mean-variance methods are used to obtain
forecasts consistent with capital market equilibrium and then present a more general
approach that can take into account different aspects of the process by which asset prices
are determined.

Mean-Variance Optimization

Quadratic programming algorithms can be used to find the portfolio that provides the
maximum expected return for a given level of standard deviation of return (Markowitz
1952). Solving such a quadratic programming problem for each of several different levels
of standard deviation of return or variance (standard deviation squared) can provide a set
of mean-variance-efficient portfolios for use in an asset allocation study.

A standard way to generate a mean-variance efficient portfolio is to maximize a function

of expected return and standard deviation of return of the form
(8)
where
d = desirability of the portfolio for the investor
e = portfolio expected return
V = portfolio variance of return
t = investor's risk tolerance

Solving the above for various levels of risk tolerance provides a set of mean-variance-
efficient portfolios. For any given risk tolerance, a mean-variance optimization requires
the following inputs:
 forecasts of asset return standard deviations,
 forecasts of correlations among asset returns,
 expected asset returns,
 the investor's risk tolerance, and
 any relevant constraints on asset holdings.

General quadratic programming algorithms or other procedures for handling nonlinear

problems may be used to perform mean-variance optimization, problems in which the
only constraints are bounds on the holdings of individual assets can be solved by using a
simpler gradient method (Sharpe 1985). In such a method, an initial feasible portfolio is
analyzed to find the best asset that could be purchased and the best asset that could be
sold, where "best" refers to the effect of a small change in holdings on the desirability of
the portfolio for the investor. As long as the purchase of the best-to-buy security
(financed by the sale of the best-to-sell asset) will increase the desirability of the
portfolio, such a swap is desirable. Next, the amount of the swap is chosen so as to
maximize the increase in the portfolio's desirability subject to constraints on feasibility.
The process is then repeated until the best possible swap cannot increase the portfolio's
desirability.

Optimal Portfolio example

In the example below there are three assets (cash, bonds, and stocks) and four possible
future states. Based on history, current conditions, and equilibrium considerations, an
analyst has produced the forecasts given in Table I. Each entry shows the total return per
rupee invested for a specific asset. Each state has an equal probability of occurring, that is
0.25. The investor's risk tolerance, t, equals 0.70

State Cash Bonds Stocks

State 1 1.03 1.05 0.80
State 2 1.03 0.97 1.09
10

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State 3 1.03 1.09 1.30
Table I: Forecasted Returns by Future Asset-Class State

The goal is thus to maximize the equation . The first step in a mean-variance
optimization is to compute the expected returns, standard deviations, and correlations of
the assets from the forecasted returns (Table I) and probabilities of states. Table II
provides these expected returns and standard deviations; and shows the correlations.

Table II. Expected Returns and Standard Deviations

Asset Expected Return Standard Deviation
Cash 1.03 0.00
Bonds 1.08 0.06
Stocks 1.12 0.18

Table III: Correlations

Cash Bonds Stocks
1.00 0.00 0.00
0.00 1.00 0.65
0.00 0.65 1.00

In this example, there are no constraints on asset holdings other than that the sum of the
proportions invested in the assets equals 1. The resulting mean-variance-optimal portfolio
is composed as shown in the first column of Table IV.

Table IV: Optimal Portfolios

Asset Mean-Variance Portfolio
Cash 0.08
Bonds 0.32
Stocks 0.60

Efficient Frontiers

We consider an investor who holds a portfolio consisting of k assets. The k-dimensional

vector of asset returns taken at time point t is denoted by Xt, t = 1, . . . , n. It is always
assumed that the second moment of Xt exists, and μ and Σ denote respectively, its mean
vector and its covariance matrix. Let w be the vector of portfolio weights and w’1 = 1,
that is, the whole investor’s wealth is shared between the selected assets. 1 denotes the k-
dimensional vector of ones. The expected return of the portfolio with the weights w is
given by R = w’μ and its variance is V = w’ Σw. Following Markowitz (1952), the
optimal portfolio weights are found by minimizing the risk of the portfolio for a given
level of the expected return. The solution of the optimization problem leads to the set of
optimal portfolios, which is called the efficient frontier.

Merton (1972) showed that the efficient frontier in the mean-variance space is the upper
part of the parabola given by

(16)
where the coefficients a = μ’ Σ-1μ, b = 1’ Σ−1μ and c = 1’ Σ−11 fully define the location
of the vertex and the slope coefficient. The set (a, b, c) is known as the efficient set
constants. Rewriting (16) one obtains
with (9)

11

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where and are the expected return and the variance of
the Global Minimum Variance (GMV) portfolio, that is, the portfolio with the smallest
risk. The quantity s = μ’ R μ denotes the slope coefficient of the parabola. The parameters
μ and Σ are usually unknown in practice. This is a well-known problem in portfolio
selection theory and it is called as the uncertainty about the parameters of the asset returns
distribution. Replacing the unknown parameters μ and Σ with estimators and leads to
sample efficient frontier of . The efficient frontier is
uniquely determined by three characteristics, viz. the mean and the variance of the GMV
portfolio and a slope coefficient.

Investment committees can decide to modify the long-term strategic asset allocation in
the medium term – say 5 years – following the eruption of factors which have an impact
on asset expected returns precisely in the medium-term. These factors can be structural
changes in the investment environment and/or economic cycles. For example, a long-term
strategic international equity portfolio may have a proportion of 20% of its stocks
invested in the Chinese market. However, if there are structural reforms in the Chinese
banking system with a likely negative influence on domestic activity in the medium-term
may have a negative impact on the Chinese expected equity returns for that time horizon.
As a result, investment managers could decide to significantly reduce the strategic
proportion of Chinese stocks for the medium-term horizon (i.e. 5 years).

Financial markets and the economic cycle

At the end of the expansion period/beginning of the contraction period, interest rates will
usually reach a relative maximum, while stock markets should start to turn bearish for a
while, as profit expectations become less optimistic. Accordingly, at this moment of the
cycle, it would be wise to raise the bond proportion with respect to stocks in a diversified
portfolio. Conversely, at the end of a contraction period/beginning of the expansion
period, interest rates are at their lows, following the weak level of activity and lower
inflation. Concerning the stock market, after a long period of stagnation or fall, company
profits should start to recover, while the required risk premium of market participants is at
its highest, as people do not yet have a clear view of profit prospects. The conditions are
established for starting a period of high equity returns and relatively low bond returns.
Thus, during these times, it is convenient to raise the proportion of stocks to bonds.

Tactical Asset Allocation

Tactical asset allocation is commonly defined as the change in the proportion of assets of
a portfolio in response to significant expected returns which should be partly materialized
in a relative short period of time, say, three to six months. Typically, these tactical
expected returns are the result of a sudden and often a large change in the required risk
premium of investors (translating into a large change in market prices), who may be
overreacting to a particular piece of information arriving to the market. For instance, the
Russian default in August 1998, followed by the September crisis of the huge hedge fund
Long-Term Capital Management (LTCM) resulted in a sharp increase of the required risk
premium of European markets, which fell by 20% during those two months. At that
period, the economic situation in Europe was quite favourable, with company profits
growing soundly. Eventually, it turned out that the market had overestimated the impact
of the crisis on the European financial system and equity markets recovered significantly
in October, though helped by the reduction of the US Fed Funds rate. If the deviation

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between the actual required risk premium of market participants and the equilibrium risk
premium – the last one consistent with the phase of the economic cycle and the structure
of the economic/financial system – is too large, there are significant chances that the
market required risk premium will move significantly towards the equilibrium risk
premium in a relative short period of time. The translation of these tactical expected
returns into tactical changes in the portfolio’s allocation can be very rewarding.
Concisely, finding a suitable long-term strategic asset allocation for the investor will
imply finding an optimal portfolio, given a set of constraints and liabilities, the investor’s
risk aversion and long-run expectations about risk and return, usually taken as constant
values. The fundamental-driven asset allocation deviates from the long-tem strategic asset
allocation, following the (smooth) evolution of equilibrium expected returns, along the
economic/financial cycle and/or important structural changes of the financial/economic
system. Tactical asset allocation deviates from the fundamental-driven asset allocation as
a result of significant deviations in the required risk premium of the market with respect
to the equilibrium risk premium – embodied in the equilibrium expected return defined
above, which are expected to translate in significant tactical returns.

We construct a market portfolio consisting of only 3 Securities ‐ RIL, L&T and ONGC.

Asset Allocation over different time periods

1997 RIL L&T ONGC G secs Market Portfolio W

Risk free Asset W

Return 12.8% 8.50% 11.50% 5% 80.1% 19.9%

Std Devn 6.50% 4.50% 6.70% 0%
Market Cap 0.31 0.22 0.47
Mark rtn 0.11243
Mar std 12% Std devn 10.65%

2001

Return 14.10% 11.20% 14% 6.30% 51.90% 48.10%

Std devn 6.40% 6.20% 6.80% 0%
Market Cap 0.36 0.21 0.43
Rtn 0.13448
Std devn 13% Std devn 9.34%

2007
Return 13.60% 8.50% 12.70% 6.70% 63.90% 36.10%
Std devn 6.20% 5.10% 5.70% 0%
Market cap 0.34 0.27 0.39
Rtn 0.11872
Std Devn 11% Std devn 9.07%

2010
Return 12% 7.50% 13.10% 7.50% 70.00% 30.00%
Std Devn 5% 4.70% 6.70% 0%
Market Cap 41% 0.28 0.31
Rtn 11%
Std Devn 11% Std devn 9.30%

Wt of Market Wt of Risk free

Results: Portfolio Portfolio

1997 80.1% 19.9%

2001 51.90% 48.10%
2007 63.90% 36.10%
2010 70.00% 30.00%

Table V: Asset allocation in various economic cycles

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Table VI: Movement of equity and risk free portfolio allocation over 14 years

CONCLUSIONS

Since last few decades many researchers and analysts have been trying to examine the
efficient market hypothesis in the asset portfolio pricing and capital market. Despite their
novel attempt, the EMH hypothesis remains a controversial issue. During any bubble,
many believe that “this time it’s different and the old rules no longer apply”. Such an
attitude was certainly true of the Asian bubble, dot com bubble, LTCM and Financial
Crisis of 2008. I believe that EMH is a model that is ideal in nature and good to start with
when evaluating market behaviour. However, it is not bulletproof and do not believe that
it rationally explains market behaviour in many instances. The concepts within
behavioural finance shed some light on the human biases that may explain the
breakdowns in EMH. I believe these inefficiencies can be exploited by long-term
investing in high quality, sustainable businesses.

Most asset allocation analyses use the mean-variance approach for analyzing the trade-off
between risk and expected return. Analysts use quadratic programming to find optimal
asset mixes and the characteristics of the capital asset pricing model to determine
reasonable optimization inputs. This article also presents a view on asset allocation and
an optimal portfolio. The goal of asset allocation is to maximize expected utility, where
the utility function may be more complex than that associated with mean-variance
analysis. This can be done by an active approach of active portfolio management or a
passive approach of through-the-door approach.

The outcome of this paper is

 Market Efficiency is questionable in business cycles and have limited
applications like the weak forms in stock market analysis
 Asset pricing theory asserts that asset prices are informationally efficient and that
capital markets are self-correcting, however the evidence of the past decade has
served to discredit the basic tenets of finance theory.

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  The stock-picking algorithm on the basis of time-delay recurrent error-correction
neural networks (ECNNs) is useful for active asset management. Passive asset
management needs a through the cycle approach on asset mean and variance.

Different levels of asset allocation can be defined, which will depend mainly on the
information used in the allocation decision process. More precisely, we made the
distinction between long-term asset allocation and fundamental-driven asset allocation,
conditional on the equilibrium expected returns in the medium term. Typically defined for
a period of around 5 years, these returns are the mirror of the “normal” expected
premiums of the financial assets, consistent with the economic cycle and/or structural
changes of the economic/financial environment.

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