I read few posts here and there about optimal level of active risk and i do not seem to understand with intuition and even by looking at the formula, what we are trying to say.
In the chapter related to optimal portfolio,it says that you have an optimal portfolio through the combination of a benchmark and actively managed portfolio. Following this definition, we have the optimal level of sharpe ratio which consists on getting the highest sharpe ratio, then we have the optimal level of portfolio risk which I think is about reducing the level of risk that the portfolio should take and then lastly, we have the optimal level of active risk which I am not sure how to make a connection. We know that the active risk is how much return you have taken more than the benchmark to generate extra return, but what does the below formula mean?
You cannot understand with intuition; intuition means knowing what’s right _ without _ understanding.
Here’s the understanding:
The optimal level of risk in your active portfolio results in the highest Sharpe ratio.
If you have less than the optimal level of risk, your Sharpe ratio will be less than the maximum. If you have more than the optimal level of risk, your Sharpe ratio will be less than the maximum.
its still not making sense
Think about it harder.
Try this: think about the Sharpe ratio of portfolios along the efficient frontier, and describe to us what you conclude.
We would pick the portfolios with the highest sharpe ratio that has the lowest amount of risk
Do you think that there are two or more portfolios along the efficient frontier that have the highest Sharpe ratio and different amounts of risk?
I want you to tell us about several portfolios along the efficient frontier and what you conclude about their risks and Sharpe ratios.