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Getting It Right: The Real Cost Impacts of a Renewables Portfolio Standard

Fortnightly Magazine - February 15 2000

tangency point between the line and the curve, now becomes the optimal mix of risky assets (M consists of 60 percent A plus 40 percent B). The solid portion of the straight line gives the risk-return combinations for portfolios consisting of the mix M plus T-bills. For example, Portfolio H consists of 50 percent T-bills plus 50 percent of the portfolio M (i.e., 50 percent T-bills, 30 percent A and 20 percent B). As more T-bills are added, the risk/ return point moves down the line (each tick mark represents a 25 percent change) until the portfolio consists of 100 percent T-bills and 0 percent M. At this point, its risk and return are 0.0 and 5 percent respectively, as shown in Figure 2.

Diversification. We now can more closely examine the powerful (and counterintuitive) impact that T-bills have on the portfolio. For example, portfolio H, which includes T-bills, has the same expected return as P (which does not), but is considerably less risky. This example (Figure 2) illustrates that by including lower-yielding but riskless assets, we can create a portfolio that produces the same expected return - 9 percent - but cuts risk nearly in half! Similarly, T-bills make it possible to move from portfolio V up to K, a move that raises return to 12 percent (from about 10.4 percent) without increasing risk.

(The gain from such moves can be even more sizeable depending on the relative risks of A and B and the risk-free rate of return. That these moves are possible illustrates why M is the optimal mix of A and B.)

With riskless assets, investors seeking risk-return combinations below M can construct portfolios such as K and H (which use a mix of M plus T-bills) that are superior to mixes that include only risky assets. That means that by adding a mixture of, for example, risky Internet stocks and T-bills, the investor can improve the annual return from Portfolio V without increasing its volatility. This powerful result, which holds in spite of the fact that T-bills yield less than either blue-chips or Internet high-flyers, has significant implications for generating portfolios, where the inclusion of riskless renewables similarly can reduce risk and/or cost.

Leverage. The dotted portion of the straight line in Figure 2 represents the additional risk-return combinations available when margin borrowing is permitted.[Fn.11] Recall that in Figure 1, the only option for raising return above M was to add more high-flyers to the mix, moving along the curve to points like S. Now, however, if an investor should want returns greater than M, she can borrow funds and use them to buy more of M, which would move her to points like N (consisting of 150 percent of M coupled with 50 percent margin borrowing).[Fn.12] Clearly margin borrowing is the better way to go: Note that N is superior to S. The implication for generating portfolios is as follows: Contractual fixed-price arrangements that are the financial equivalent of margin borrowing will improve overall performance.

To summarize, investors will adjust their risk return point to suit