Page 494 - Introduction to Business

468 PART 5 Finance

that portfolios on curve EF are optimal. These portfolios are efficient in the sense
efficient frontier The set of portfolios of
assets that has minimum risk over a that they minimize risk for any given level of return. For this reason the curve EF is
range of expected returns called the efficient frontier.
One possibility that is missing in Exhibit 13.11 is that an investor will seek to
entirely avoid risk. For example, if an extremely risk-averse investor desired to

EXHIBIT 13.11 avoid risk, she or he could put her or his money in a bank deposit
account. While very safe, the rate of return, or interest earned, on
Efficient Frontier of Investment a bank account is minimal. This riskless rate of return is shown as
Opportunities
the point labeled Z on the Y axis in Exhibit 13.11. Asset Z has no
Combinations or portfolios of bonds and stocks that
risk but has a minimum rate of interest. Another example of a risk-
have minimum risk for any given return.
less asset is short-term government debt securities, such as U.S.
Treasury bills.
F
Suppose that the investor can choose between riskless asset Z
and a risky portfolio on the efficient frontier EF. If she or he put
Increasing return S 1 S 2 S 3 S 4 50 percent of her or his money in asset Z and 50 percent in a portfo-
lio lying on the curve EF, which portfolio would be the best one
to choose?
B 3
Exhibit 13.12 gives the solution. Looking at the graph, we see that
B 1
S 1 S 5 the highest return per unit risk is achieved by investing in portfolio
B 4 B 2
M. This portfolio is obtained by finding the line just tangent to
B 5
E
the curve EF, the solid line in Exhibit 13.12. If you picked portfolio N,
Increasing risk
you can readily see that the dashed line ZN is below the solid line
Stocks: S 1 . . . S 5 Bonds: B 1 . . . B 5
ZM. All investors will pick the same optimal portfolio, portfolio
M. Portfolio M is named the market portfolio due to this rather
EXHIBIT 13.12
startling finding.
Market Portfolio M, Riskless Asset Z, and What kinds of assets are contained in portfolio M? In theory, all
the Capital Market Line
assets in the world are contained in M. In practice, studies have
All investors will invest in some combination of risk- found that portfolios with only 30 to 50 stocks and bonds are fairly
less asset Z and market portfolio M, which is the capi-
good approximations for portfolio M. Many people use broad
tal market line. This line gives the highest return-risk
stock indexes, such as the Standard & Poor’s 500 index or the Dow
trade-off.
Jones World Stock index, to estimate portfolio M. Three-month or
one-year U.S. Treasury bills are used to estimate the riskless rate at
Capital
market line F point Z.
In choosing investments, investors who are extremely risk averse
Increasing return M bills (point Z in Exhibit 13.12). Investors seeking considerable levels
Efficient frontier
should put all of their money in a bank account or in U.S. Treasury
of risk should put all of their money in market portfolio M. Investors
money so they will be somewhere along the line ZM. The investors’
N wanting some balance between these two points should divide their
risk preferences determine where they will lie on the line ZM. The
Z E
line ZM is known as the capital market line.
Investors do not have to work to find the highest earning
Increasing risk
stocks. All they need to do is properly diversify by purchasing market
market portfolio The portfolio of assets portfolio M. Nowadays it is quite easy to buy portfolio M. For example, investment
that investors should purchase to earn companies sell a wide variety of stock index portfolios. Also, exchange traded
the highest return-risk trade-off
funds (ETFs) that represent a diversified portfolio of securities on the Ameri-
capital market line The line that shows
the return-risk trade-off available to can Stock Exchange offer stocks to investors. These innovations in financial
investors, who have a choice between a markets allow investors to readily achieve return-risk levels on the capital market
riskless asset and the market portfolio line.
exchange traded funds (ETFs) Diversified
portfolios of securities offered by the Amer- reality
ican Stock Exchange that can be bought CH ECK How would you invest your retirement money to maximize the returns
and sold as individual stocks can be per unit risk? Is your investment portfolio diversified?

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