Modern Portfolio Theory and Investment Analysis, 9th Edition

11

How to Select among the Portfolios in the Opportunity Set

In Chapter 1, we pointed out that to solve any decision problem, one needed to define an opportunity set and a way to pick the optimum portfolio from the opportunity set. The subject of earlier chapters was how to obtain an opportunity set. The subject of this chapter is picking the optimum portfolio. In what follows, we discuss various techniques that have been proposed for selecting the optimum portfolio.

CHOOSING DIRECTLY

The simplest way to select among portfolios in the opportunity set is to directly compare them. Many investment professionals and academics are skeptical concerning the investor's ability to specify the trade-offs necessary to implement more formal procedures for making these choices.

Consider the three portfolios shown in Table 11.1. These portfolios are associated with an efficient frontier assuming riskless lending and borrowing. The Tangency Portfolio has an expected return of 10 and a standard deviation of 10, and the risk-free rate is 4%.

How can an investor directly choose among these portfolios? Normally, investors don't think in terms of expected return and standard deviation of return so that the investor or her advisor often expresses the choice in terms of the likelihood of outcomes that might be important to the investor. Alternatively, the advisor can present the investor with probability distributions representing the payoff for various alternatives.

First, consider expressing the choice ...