Portfolio Theory

Question 1

What is portfolio theory?

Answer 1

Portfolio theory explains how to combine different investments (assets) to maximise return for a given level of risk, or minimise risk for a given return.
It shows that by diversifying (investing in multiple assets), you can reduce total risk — especially if the assets don’t move in the same direction.

Question 2

What is the efficient frontier?

Answer 2

The efficient frontier shows the smartest, most efficient portfolios — giving you the best deal between risk and reward.
Best ones lie on the efficient frontier

• The highest possible return for a given level of risk,
or
• The lowest possible risk for a given level of return.

Question 3

What happens when we add a risk-free asset?

Answer 3

When a risk-free asset (like government bonds) is added, the best combinations lie on a straight line called the Capital Market Line (CML).
This line shows mixes of:
• 100% in risk-free
• Some in risk-free, some in risky (the market portfolio)
• Even borrowing to invest more in risky assets
The slope of the CML is the Sharpe Ratio — showing how much return you get per unit of risk.

Question 4

What do investors prefer and how do they choose portfolios?

Answer 4

Investors prefer:
• Higher return
• Lower risk
They choose portfolios on the efficient frontier, or on the CML if a risk-free asset is available.
They avoid dominated portfolios (which have higher risk AND lower return).
Risk-averse investors will hold more of the risk-free asset, while risk-takers may borrow (leverage) to invest more in risky assets.