Lesson 8 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 8 of 8 · 14 min
Optimal risky portfolio and the optimal investor portfolio
Adding a risk-free asset turns portfolio choice into two steps: everyone picks the same optimal risky portfolio, then each investor chooses how much to lend or borrow.
In short
- Combining the risk-free asset with any efficient portfolio gives a CAL; the best one is the steepest, tangent to the efficient frontier.
- The tangency portfolio is the optimal risky portfolio; its CAL dominates every other CAL and the efficient frontier (except at the tangency point).
- Two-fund separation: all investors hold the risk-free asset and the same optimal risky portfolio.
- Step 1, the investment decision, ignores preferences; step 2, the financing decision, uses each investor's indifference curves.
- Highly risk-averse investors sit near (lending); less risk-averse investors sit at or beyond the optimal risky portfolio (borrowing).
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