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I'm wondering whether there would be a change to my answer of the change in portfolio when there is a new stock introduced.

My investment strategy is to maximise expected return such that my standard deviation is not more than 15%. Suppose I believe in CAPM (so I should hold a combination of the market portfolio and the riskless asset).

The original expected return of the market is 0.10, standard deviation is 0.20. The expected return of the riskless asset is 0.03. The new stock that was introduced has an expected return of 0.168 and a standard deviation of 0.30. The correlation of this stock with the market is 0.20.

Assuming the new stock now gives a higher rate of return ($r=0.168$) than the required rate of return that was calculated from CAPM. How would this change my existing strategy in allocating my portfolio. My existing portfolio is a combination of the original market portfolio ($w_1=0.75$) and the riskless asset ($w_2=0.25$).

I think that this would change my strategy as I would consider recalculating my market portfolio. This is suggesting that the original market portfolio is now considered as "risky asset 1" and the new stock is "risky asset 2". Using the two-fund separation approach, a new tangency portfolio is calculated and is different from the existing portfolio. I am concerned that the strategy would not change because the change in price in the new stock may not affect the existing market portfolio.

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  • $\begingroup$ I don't understand the statement "I am concerned that the strategy would not change" when you have just explained very clearly how the strategy does change. Even if the return on the new stock is the same as the old stock you benefit by diversification in including the new stock. $\endgroup$ – noob2 Jan 11 '16 at 14:25

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