OPTIMAL PORTFOLIO SELECTION OF BONDS AND STOCKS*

ABSTRACT In the present study, we offer an alternative approach to bond portfolio management which differs from the traditional immunization approach. In doing so, we formalize what has been a common practice among some investors who form portfolios of bonds and stocks with a view to optimizing the trade‐off between risk and return. By using the general multiindex model to characterize the variance‐covariance structure of security returns, both duration theory and modern equilibrium theories of the term structure are incorporated in the analysis. In addition, a simplified selection procedure based on a single‐index model is derived. This procedure is intuitively appealing to practitioners since it selects assets on the basis of reward per unit of risk of individual assets.