Question

Chapter 25 explains that is is better for investors to have some money invested in a risk-free asset and the remaining money in a stock market portfolio or stock-bond portfolio. A risk-free asset by definition will protect your initial investment (no default risk) even though it may not provide any return. Although we often use T-bill return as a risk-free return, your FDIC checking/savings accounts may be regarded as a risk-free asset up to the FDIC protection limit. Remember that the return to risk ratio from the new efficiency frontier with the risk-free asset (i.e. CML) is better than from the old efficiency frontier with no risk-free asset. Explain why the addition of a risk-free asset will lower the overall portfolio risk and raise the return to risk ratio.

Answer 1

Addition of risk free asset is always important to give stability to your portfolio in case of recessions or market turmoil due to global and political risks.The risk free assets will lower your return and will provide stability and hence you as the investor can take informed decisions on the asset allocation.It is important to add the risk free asset based on your age and the length of investments. For example if you just retired and had a huge corpus to invest. Suppose, say you are of age 65, then investing 65% in a risk free asset is recommended and 35% in stock funds. The basic thumb rule of investment is to invest "100-age" in risky assets or equity and the rest in risk free assets.