As seen previously, adjusting for the risk of an asset using the risk-free rate, an investor can easily alter his risk profile. Keeping that in mind, in the context of the capital market line (CML), the market portfolio consists of the combination of all risky assets and the risk-free asset, using market value of the assets to determine the weights. The CML line is derived by the CAPM, solving for expected return at various levels of risk.
Markowitz' idea of the efficient frontier, however, did not take into account the risk-free asset. The CML does and, as such, the frontier is extended to the risk-free rate as illustrated below:
Systematic and Unsystematic Risk
Total risk to a stock not only is a function of the risk inherent within the stock itself, but is also a function of the risk in the overall market. Systematic risk is the risk associated with the market. When analyzing the risk of an investment, the systematic risk is the risk that cannot be diversified away.
Unsystematic riskis the risk inherent to a stock. This risk is the aspect of total risk that can be diversified away when building a portfolio.
Total risk = Systematic risk + Unsystematic risk
When building a portfolio, a key concept is to gain the greatest return with the least amount of risk. However, it is important to note, that additional return is not guaranteed for an increased level of risk. With risk, reward can come, but losses can be magnified as well.
The Capital Asset Pricing Model (CAPM)
InvestingThe capital market line (CML) depicts the level of additional return above the risk-free rate for each change in the level of risk.
InvestingFollow these tips to successfully manage portfolio risk.
InvestingSystematic risk, also known as volatility, non-diversifiable risk or market risk, is the risk everyone assumes when investing in a market. Think of it as the overall, aggregate risk that comes ...
InvestingMarket risk is the chance that an investment’s value will decrease due to a factor that affects all investments across the market.
InvestingUnsystematic risk is the part of an investment’s risk that is attributable to the investment itself — not to the entire economic system.
InvestingMarket risk premium is equal to the expected return on an investment minus the risk-free rate. The risk-free rate is the minimum rate investors could expect to receive on an investment if it ...
InvestingCAPM helps you determine what return you deserve for putting your money at risk.
Managing WealthSee why investors today still follow this old set of principles that reduce risk and increase returns through diversification.
InvestingThe risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free ...