Question

7) According to standard portfolio theory, explain how an investor would determine the following:

       a) how to allocate his/her savings amongst the risky assets available in the economy

b) how to allocate his/her savings between the optimal risky portfolio identified in part (a) and the risk-free asset

Answer 1

a) First, an efficient frontier is created by finding the minimum variance portfolio at each level of return of the portfolio. The line connecting the points of risk-free asset and the efficient frontier is called capital allocation line which slope indicates the return to risk ratio. To allocate savings among risky assets, the weights should be allocated such that the return to risk ratio is maximum i.e. the tangency portfolio at which the CAL is tangent to the efficient frontier. Thus the weight for each risky asset in the optimal portfolio can be found.

b) To allocate weights among the risk-free asset and optimal risky portfolio, the utility function of the investor is used. The weights should be allocated such that the utility of the investor is maximum. Utility function included the return, standard deviation, and risk aversion coefficients.