Question

Weights, standard deviation, and average returns for 50 stocks and a market index are known. The covariance matrix and correlation is also known. We need to "Pick 5 assets and explain the reason why you choose them". On what basis (Eg. The ones with the highest returns, low standard deviation, etc.)  should we pick our stocks?

Answer 1

This question is subjective and hence one might have a different preference or way of choosing these stocks. This majorly has to do with the fact that every individual has different risk capability and hence the return that they expect is also different.

Now, having said that, I believe the portfolio of the 5 stocks should be chosen such that there's a balance of everything - when I say everything I mean - the portfolio should be well diversified, 2 of the stocks should have low standard deviation, there should be 2 stocks having good average return over a period of lets say 3 years.

Assuming that we're looking for a long term investment, we need to see the data for atleast 5 years and see how much return these stocks have given.

We also tend to look at the industry that these stocks belong to. and we need to make sure that they're from different industry. When we choose these assets we try and select from those industry where we see the future is bright and we believe that the company would do good in the coming future.

For Eg - Online shopping in India was not anticipated 5 years back and now offline shopping is getting affected badly because of the emergence of online revolution.

So, one must be able to anticipate what's coming and what might be the changing point for certain industries in the coming future. This surely helps in identifying the best stocks for your portfolio.