Delineating Efficient Portfolios

In Chapter 4 we examined the return and risk characteristics of individual securities and began to study the attributes of combinations or portfolios of securities. In this chapter we look at the risk and return characteristics of combinations of securities in more detail. We start off with a reexamination of the attributes of combinations of two risky assets. In doing so, we emphasize a geometric interpretation of asset combinations. It is a short step from the analysis of the combination of two or more risky assets to the analysis of combinations of all possible risky assets. After making this step, we can delineate that subset of portfolios that will be preferred by all investors who exhibit risk avoidance and who prefer more return to less.1 This set is usually called the efficient set or efficient frontier. Its shape will differ according to the assumptions that are made with respect to the ability of the investor to sell securities short as well as her ability to lend and borrow funds.2 Alternative assumptions about short sales and lending and borrowing are examined.


In Chapter 4 we began the analysis of combinations of risky assets. In this chapter we continue it. Previously, we treated the two assets as if they were individual assets, but nothing in the analysis so constrains them. In fact, when we talk about assets, we could equally well be talking about portfolios of ...

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