Application of portfolio optimization using pension and other 6 stocks

Abstract

This paper uses the Capital Asset Pricing Model and Fama-French Three-Factor Model (FF3F) to construct optimal portfolios with maximized Sharpe ratio, aiming to help retired firefighters decide between the pension’s annual benefits and the lump sum of the pension. Firstly, this paper selects six well-diversified assets from different industries. Secondly, this study estimates the expected return of each asset using the CAPM and FF3F Model, respectively. Thirdly, this paper constructs two ‘With Pension Portfolio’s using the expected return from the two models. Fourthly, this paper also builds two portfolios using the same results from the two models but keeping the pension’s weight to zero. By comparing the maximized Sharpe ratios from ‘With Pension Portfolio’s and ‘Without Pension Portfolio’s, we conclude that the firefighter should choose to take the benefits of the pension. The results in this paper can serve as a reference for retired people when they want to allocate their nest egg and pension better.