How to allocate portfolio weight based on the FF3F model

Abstract

Selecting the correct stocks and funds is essential for portfolio management and allocation. In order to reduce the risk of the portfolio, it is better to diversify the assets and select the stocks within more than one sector. Another step would be setting the portfolio with the firefighter case or without it. The firefighter case illustrates that we suppose there is a firefighter who has 25 years of service as a firefighter who will be retired in Florida. The Florida government gives the retired firefighter two choices. He takes the lump-sum payout and invests his nest egg and the lump sum in supporting him throughout his retirement. Another one is that he takes the pension benefit and invests his nest egg in supplementing the pension benefit. In this case, we compared those two and finally selected the one in which he maintained the pension and made the pension weight precisely equal to 71%. The Sharpe ratio for this scenario is relatively higher than the another. Moreover, choosing the correct financial model. Comparing the pros and cons between the CAPM model and the Fama French Three-Factor model, we found that the Fama French Three-Factor model is more related to reality and includes the market risk, making the portfolios more accurate and reliable.