x. Question 1: Which method of portfolio selection, Toms “RandomWalk

QUESTION

x.
Question 1: Which method of portfolio selection, Toms “RandomWalk”or Johns Fundamentalist approach is better? Which requiresmore effort? Are expected rewards different? It depends on the number of stocks in the portfolio and theresulting “w” or weight that the candidate stock will have in thenew portfolio. For small portfolios, Johns Fundamentalistapproach is better than Toms Random Walk approach. For largeportfolios Toms Random Walk approach will be better, require lesseffort, and have expected rewards consistent with the overallmarket return. When there are only 3 existing technology stocks, then the newlyselected stock could well represent 25% of the new portfolio andhave a material effect on portfolio risk; especially if it had bothhigh correlation and high volatility. If Toms Random Walkdartboard selected yet another technology stock (a non-zeroprobability), then portfolio risk could very well increase.

ohnsFundamentalist approach selection of a consumer goods(non-technology!) sector stock with very low correlation would mostlikely measurably reduce portfolio risk, and be worth the analyticeffort. This is especially so because of the small portfolio sizein which the incremental stock selected carries a “w” weight of20-30%. OTH, the larger a portfolio, the lower “w” and the more efficientbecomes Toms “random walk” approach. For a 99 stock portfolio, “w”weighting is 1%. There comes a point where Toms “random walk”approach is, in fact, simply holding the market portfolio in theform of an S&P 500 index fund.

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