Financial Concepts: The Optimal Portfolio
AAA
  1. Financial Concepts: Introduction
  2. Financial Concepts: The Risk/Return Tradeoff
  3. Financial Concepts: Diversification
  4. Financial Concepts: Dollar Cost Averaging
  5. Financial Concepts: Asset Allocation
  6. Financial Concepts: Random Walk Theory
  7. Financial Concepts: Efficient Market Hypothesis
  8. Financial Concepts: The Optimal Portfolio
  9. Financial Concepts: Capital Asset Pricing Model (CAPM)
  10. Financial Concepts: Conclusion

Financial Concepts: The Optimal Portfolio


The optimal portfolio concept falls under the modern portfolio theory. The theory assumes (among other things) that investors fanatically try to minimize risk while striving for the highest return possible. The theory states that investors will act rationally, always making decisions aimed at maximizing their return for their acceptable level of risk.

The optimal portfolio was used in 1952 by Harry Markowitz, and it shows us that it is possible for different portfolios to have varying levels of risk and return. Each investor must decide how much risk they can handle and than allocate (or diversify) their portfolio according to this decision.

The chart below illustrates how the optimal portfolio works. The optimal-risk portfolio is usually determined to be somewhere in the middle of the curve because as you go higher up the curve, you take on proportionately more risk for a lower incremental return. On the other end, low risk/low return portfolios are pointless because you can achieve a similar return by investing in risk-free assets, like government securities.


You can choose how much volatility you are willing to bear in your portfolio by picking any other point that falls on the efficient frontier. This will give you the maximum return for the amount of risk you wish to accept. Optimizing your portfolio is not something you can calculate in your head. There are computer programs that are dedicated to determining optimal portfolios by estimating hundreds (and sometimes thousands) of different expected returns for each given amount of risk. Financial Concepts: Capital Asset Pricing Model (CAPM)

  1. Financial Concepts: Introduction
  2. Financial Concepts: The Risk/Return Tradeoff
  3. Financial Concepts: Diversification
  4. Financial Concepts: Dollar Cost Averaging
  5. Financial Concepts: Asset Allocation
  6. Financial Concepts: Random Walk Theory
  7. Financial Concepts: Efficient Market Hypothesis
  8. Financial Concepts: The Optimal Portfolio
  9. Financial Concepts: Capital Asset Pricing Model (CAPM)
  10. Financial Concepts: Conclusion
RELATED TERMS
  1. Endowment Effect

    The endowment effect describes a circumstance in which an individual ...
  2. Self-enhancement

    The self-enhancing bias is the tendency for individuals take ...
  3. Gamification

    Gamification describes the incentivization of people's engagement ...
  4. Anchoring and Adjustment

    Anchoring and adjustment is a cognitive error described by behavioral ...
  5. Sample Size Neglect

    Sample size neglect occurs when an individual infers too much ...
  6. Smart Beta

    Investment strategies that emphasize the use of alternative weighting ...
  1. How is correlation used differently in finance and economics?

    Take a look at the similarities and differences between how statistical correlation is applied in economics as opposed to ...
  2. How is correlation used to measure volatility?

    See how the correlation between an asset and its benchmark index can be used as a proxy to determine the relative volatility ...
  3. How is correlation used in modern portfolio theory?

    Discover how modern portfolio theory and the efficient frontier use correlation between investment assets to predict an optimal ...
  4. Are warrants more desirable than options?

    Understand what stock warrants are, the differences between warrants and options, and learn whether warrants or options are ...

You May Also Like

Related Tutorials
  1. Fundamental Analysis

    Ethical Investing Tutorial

  2. Bonds & Fixed Income

    Investing For Safety and Income Tutorial

  3. Economics

    American Depositary Receipt Basics

  4. Economics

    Macroeconomics

  5. Investing Basics

    Capital Budgeting

Trading Center