Category: portfolio theory
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Capital allocation line
When a risk-free asset exists in an economy, investors can add that asset to their portfolios if they wish so. In the risk-return space, the combination of the risk-free asset and any risky asset is a straight line. This line is called the capital allocation line as it shows how an investor’s capital is allocated…
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Market portfolio
We have so far learned how to calculate the risk and return of portfolios and how to trace an efficient frontier through mean-variance optimization. It is now time to introduce a special portfolio that will play a significant role when we discuss the CAPM: The market portfolio. What is the market portfolio? The market portfolio is the…
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Minimum variance portfolio
In a market with multiple risky assets, the minimum variance portfolio is a particular combination of those assets that yields the minimum volatility. To be more specific, consider the market depicted in Figure 1. Here, the blue curve represents the efficient frontier. That is, all portfolios that lie on it are efficient portfolios (e.g., D…
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Efficient frontier calculator
In modern portfolio theory, the efficient frontier represents the collection of all efficient portfolios within a market. Efficient portfolios offer the best risk-return tradeoff and, as such, are superior to inefficient portfolios, which are suboptimal. In this lesson, we explain how investors can trace the efficient frontier using mean-variance optimization (the topic of the previous…
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Mean-variance optimization
According to modern portfolio theory, investors are concerned about the “mean” and “variance” of asset returns, where the former captures the “centrality” and the latter the “spread” (or “riskiness”) of potential returns. As such, investors engage in mean-variance optimization. That is, they seek the portfolios that offer the best tradeoff between risk and return. In…
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Idiosyncratic risk
What is idiosyncratic risk? It is the type of risk that affects either a single security such as a stock or a small group of securities. This is in contrast to systematic risk, which affects all risky securities in a particular market. The word “idiosyncratic” does not commonly feature in daily language. Many people may…
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Optimal risky portfolio
In previous lessons, we explained that when there is no risk-free asset in an economy, investors should invest in one of the efficient portfolios that lie on the efficient frontier based on their risk tolerances. But, if a risk-free asset exists, then there is a unique efficient portfolio that all investors should invest in. In…
