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Asset allocation by using the Sharpe rule: How to improve an existing portfolio by adding some new assets?

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  • Kwok Wai Yu

    (The Hong Kong Polytechnic University, Hung Hom, Kowloon)

  • Xiao Qi Yang
  • Heung Wong

Abstract

This paper discusses the applications of the Sharpe rule in portfolio measurement and management. It proposes that a portion of the portfolio value should be invested in some other assets for portfolio improvement. By applying the Sharpe rule, it can be determined that new stocks are worthy of adding to the old portfolio if they satisfy a condition, in which the average return rate of these stocks is greater than the return rate of the old portfolio multiplied by the sum of the elasticity of the Value at Risk and 1. One attraction of our approach is diversification. A numerical example in the Hong Kong stock market is presented for illustration. Consideration is also given to the ‘optimal’ number of new assets to be added in two specific cases (ie, arithmetic series and geometric series regarding the sequences of expected returns and standard deviations). Some interesting simulation results show that a new portfolio with the ‘highest’ Sharpe ratio can be obtained by adding only a few new assets.

Suggested Citation

  • Kwok Wai Yu & Xiao Qi Yang & Heung Wong, 2007. "Asset allocation by using the Sharpe rule: How to improve an existing portfolio by adding some new assets?," Journal of Asset Management, Palgrave Macmillan, vol. 8(2), pages 133-145, July.
    • Handle: RePEc:pal:assmgt:v:8:y:2007:i:2:d:10.1057_palgrave.jam.2250067
    DOI: 10.1057/palgrave.jam.2250067
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    References listed on IDEAS

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    1. Dowd, Kevin, 2000. "Adjusting for risk:: An improved Sharpe ratio," International Review of Economics & Finance, Elsevier, vol. 9(3), pages 209-222, July.
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