Problem
Scenario
You are reviewing a taxable client portfolio in Merrill Guided Investing after a market pullback. The client is currently concentrated in U.S. equities, has asked for a more efficient allocation, and wants to keep the expected annual return at or above 7.0% while reducing risk. You can use only three asset sleeves already approved on the Merrill platform: U.S. equity, investment-grade bonds, and short-term Treasuries. Ignore taxes and trading costs for this exercise.
Financials
| Metric | U.S. Equity | Investment-Grade Bonds | Short-Term Treasuries |
|---|---|---|---|
| Expected annual return | 9.0% | 5.0% | 3.0% |
| Annual volatility | 18.0% | 7.0% | 2.0% |
| Correlation with U.S. Equity | 1.00 | 0.20 | 0.00 |
| Correlation with Investment-Grade Bonds | 0.20 | 1.00 | 0.10 |
| Correlation with Short-Term Treasuries | 0.00 | 0.10 | 1.00 |
Current portfolio weights: 70% U.S. equity, 20% investment-grade bonds, 10% short-term Treasuries.
Question
How would you optimize the allocation to reduce portfolio volatility while keeping expected return at or above 7.0%, and what rebalanced mix would you recommend to the client?
Key Inputs
What This Tests
- Expected return calculation
- Portfolio variance and volatility
- Use of correlation in diversification
- Constrained portfolio optimization
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