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Adding a new investment in the portfolio

“If the Sharpe ratio of the new investment is greater than the current portfolio Sharpe ratio multiplied by the correlation of the new investment’s returns with the portfolio’s returns, adding the investment to the portfolio will improve the portfolio Sharpe ratio”

Can someone explain the logic behind this?

My reasoning is this but please correct me if I am wrong.

There are two factors to consider when deciding whether you should add a new asset to the portfolio: 1. it’s individual risk and return (sharp ratio) and 2. the asset’s correlation with the portfolio.

Now since it states that the individual asset’s sharp ratio must be larger than the portfolio’s sharpe ratio multiplied by the correlation of the asset with the portfolio, it is essentially saying that the individual assets return over risk must be higher than the effects that the correlation has to the portfolio when adding a new asset. So for instance, if an asset is uncorrelated with the portfolio, the correlation effects could bring down the total return of the portfolio, but tinsce the sharpe ratio is higher, you should select. Does this make sense?

The Doobs

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“if an asset is uncorrelated with the portfolio, the correlation effects could bring down the total return of the portfolio, but tinsce the sharpe ratio is higher, you should select. Does this make sense?”

If an asset is uncorrelated with the portfolio, then adding the said asset to the portfolio would be beneficial from the diversification point of view. The lower the correlation, the stronger is the argument for adding the asset to the portfolio. If correlation is lower than 1 it will lower the second term of the equation that you mentioned - port’s sharpe ratio x correlation of asset with port. The expected return of the asset should be viewed in relation to risk of the asset, therefore you use sharpe ratio. (The expected return on the new asset may be lower than that of the old portfolio, but it may make sence if it’s risk is lower -> higher sharpe ratio.) Overall, if the Sharpe ratio of the new asset is high, and the correlation with existing port. is low, you add the asset.