Lesson 3 of 8 · All lessons in this module
- Asset classes: return, risk and other characteristics
- Risk aversion and utilityVideo lesson
- Indifference curves and the capital allocation lineVideo lesson
- Measuring asset and portfolio riskVideo lesson
- Correlation and the power of diversificationVideo lesson
- Integrated cases: a foreign bond with currency, and pairs from a scenario table
- Minimum-variance and efficient frontiersVideo lesson
- Optimal risky portfolio and the optimal investor portfolioVideo lesson
Lesson 3 of 8 · 14 min
Indifference curves and the capital allocation line
Indifference curves show what an investor wants, the capital allocation line shows what is available, and the optimal portfolio is where the two just touch.
In short
- An indifference curve links risk–return pairs that give one investor the same utility.
- Risk-averse curves slope upward and are convex; steeper curves mean more risk aversion. Utility rises toward the northwest. One investor's curves never cross.
- Risk-neutral curves are horizontal; risk-seeker curves slope downward.
- Combining a risk-free asset with a risky portfolio gives the capital allocation line (CAL): .
- Left of the risky portfolio the investor lends at ; right of it the investor borrows at to invest more than 100%.
- The optimal portfolio is the tangency point between the CAL and the highest indifference curve that touches it.
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