1. The portfolio weights
In the previous example,
2. Investment decision choices
I intentionally chose two companies selling a similar product. Still, the analysis showed that the value of the stocks can diverge over time.
So how to decide between those two companies? Flip a coin?
3. Investment decision choices
No! In most cases, the rational decision is not to invest in either one
4. Investment decision choices
or the other, but to reduce our risk by holding
5. Investment decision choices
a portfolio that is invested in both of them. This is called diversifying your risks.
6. Investment decision choices
So how good is your portfolio diversification? To answer this question
7. Investment decision choices
you need to investigate how the
8. Investment decision choices
portfolio investments are spread across the different assets.
9. Investment decision choices
This is done by computing
10. Investment decision choices
the portfolio weight of each asset. This means that we compute the ratio between the value of one investment, relatively to the total value of all the investments in the portfolio.
11. Asset weighting
Suppose, for example, that there are N different investments, each with their own value Vi. Then the weight of investment i equals Vi divided by the sum of the value of all the investments in the portfolio.
12. Calculating weight
The corresponding R code is simple. Suppose that values is the vector holding the values invested in the different assets. Then the corresponding weight vector is simply that vector of values divided by its sum.
13. Calculating weight
Of course, this vector sums to unity.
14. Allocation strategies
In Chapter 4
15. Allocation strategies
we will see how to optimize the choice of portfolio weights. In the meantime, it is important to know that several approaches exist to set the portfolio weights.
A first approach is to concentrate the investment bet
16. Allocation strategies
in one risky asset. This approach is speculative and very likely to be inefficient. When all assets are similar in terms of risk and reward, a better approach is to aim for perfect diversification
17. Allocation strategies
and to invest the same amount in each risky asset. This the so-called equal weighting approach. Another popular approach is to set weights proportional to the
18. Allocation strategies
market value of the asset. It implies overweighting stocks of big firms and underweighting stocks of small firms. These are only a few examples of the large number of possible approaches to define portfolio weights.
For us, the important conclusion to remember is that to avoid extreme losses, it is definitely not a good idea to put all your
19. Don't put all your eggs in one basket
eggs in one basket.
20. Let's practice!