A 32 year old investor with risk-aversion parameter of 5 expects the return on the market portfolio (S&P500 Index) to be 12% per year with a standard deviation of 20% per year. The risk-free rate is 1% per year.

(a) What percent of his capital should this person invest in the market portfolio (or a S&P 500 Index fund) following the traditional rule of thumb?

(b) What percent of his capital should this person invest in the market portfolio using the utility based optimal asset allocation method?

Suppose new economic news suggests that the market is expected to provide return of 10% per year and is expected to be a little more volatile: standard deviation of 22% per year.

(c) What will be the percent of capital that this person should invest in the market portfolio based on these new estimates? Comment on the change in asset allocation.

Answer rating: 100% (QA)

a The traditional rule of thumb suggests that an investor should invest a percentage in the market portfolio equal to their risk aversion parameter di... View the full answer