Optimal Portfolio

Abstract

In addition to the return–risk characteristics of the assets, the investor’s attitude to risk must also be taken into account in order to achieve the investment objectives. This chapter demonstrates how the efficient frontier is combined with the investor-specific indifference curves to arrive at the optimal risky portfolio. The efficient frontier is constructed using capital market data with the expected return and standard deviation of returns on individual assets and the covariance or correlation coefficient between returns of pairs of assets. Indifference curves, by contrast, measure the benefit the investor gains from holding the portfolio. In calculating the benefit or utility, relevant factors include the degree of risk aversion of an individual investor, in addition to the expected return and the risk. The point of contact between the efficient frontier and the highest possible investor-specific indifference curve represents the optimal portfolio of risky assets. If the risk-free asset is included in the portfolio construction, the optimal portfolio lies on the most efficient capital allocation line. Assuming that market participants have identical (homogeneous) capital market expectations, then all investors invest in the same portfolio of risky assets or market portfolio. All investment combinations of the risk-free asset and the market portfolio lie on the capital market line.