Question

Q5. Discuss the followings in the context of portfolio theory, developed by Harry Markowitz: a) What is meant by a risk-averse investor? b) What is meant by a Markowitz efficient frontier? c) Explain why not all feasible portfolios are on the Markwitz frontier. d) What is meant by an optimal portfolio, and how it is related to an efficient portfolio? e) How does an investor select an optimal portfolio? Explain the role of an investor's preference in selecting an optimal portfolio Explain the critical role of the correlation between assets in determining the potential benefits from diversification g) What have been the major impediments to applying the mean-variance framework in practice?

Answer 1

a) risk averse investor refers to the person who, when faced with two investments with a similar expected return prefers the one with lower risk. A risk averse investor dislikes risk and therefore stays away from high risk stocks or investments and is prepared to forego higher rates of return. It is the behavior of an invested when exposed to uncertainity, attempts to lower that uncertainity.

B) according to markowitz, for every point on the efficient frontier there is atleast one portfolio that can be constructed from all available investments that has the expected risk and return corresponding to that point. It says that different combination of securities produce different levels of return. The efficient frontier represents the best of these securities combinations.

C) As the portfolios that lie below the efficient frontier are sub optimal because they do not provide enough return for the risks. Portfolios that cluster to the right of the efficient frontier are sub optimal because they have a higher level of risk for the defined rate of return. There is no efficient frontier because portfolio managers and investors can edit the numbers and characteristics of the securities to conform to their specific needs.

D) optimal portfolio refers to the one portfolio on the efficient frontier with the highest return to risk combination given the specific investors tolerence for risk. Its the point where the efficient frontier and the indifference curve meets.