Tangent The Investor's Optimal Portfolio Moves example essay topic

This assignment is concerned with your understanding of the key issues relative to portfolio analysis and investment. In completing this assignment you are to limit your scope to the US stock markets only. Use the Cybrary, the Internet, and course resources to write a 2-page essay which you will use with new clients of your financial planning business which addresses the following issues and / or practices: o How individual investors make investment decisions in practice rather than in theory; and o How investors manage their funds / savings / investments in light of current stock markets. In your response, build upon extant portfolio theory and make sure to talk about different types of risks that investors might face and how they go about managing such risks.

This means you need to consider topics such as efficient frontier and optimal portfolios; as well their relevance to investment theory. Furthermore, given the nature of the assignment, avoid bringing the brokerage industry into your discussion. In other words, assume you can invest directly in the stock market and do not need any financial intermediaries like brokerage houses. Investment theory is based upon some simple concepts. Investors should want to maximize their return while minimizing their risk at the same time.

In order to accomplish this goal investors should diversify their portfolios based upon expected returns and standard deviations of individual securities. Investment theory assumes that investors are risk averse, which means that they will choose a portfolio with a smaller standard deviation. (Alexander, Sharpe, and Bailey, 2004). It is also assumed that wealth has marginal utility, which basically means that a dollar potentially lost has more perceived value than a dollar potentially gained. An indifference curve is a term that represents a combination of risk and expected return that has an equal amount of utility to an investor. A two dimensional figure that provides us with return measurements on the vertical axis and risk measurements (std. deviation) on the horizontal axis will show indifference curves starting at a point and moving higher up the vertical axis the further along the horizontal axis it moves.

Therefore a risk averse investor will choose an indifference curve that lies the furthest to the northwest because this would represent the maximum expected amount of return vs. risk for a portfolio. In practice investors are not totally rational. They are subject to the effects of framing upon financial scenarios that cause them to choose an option that provides less utility due to cognitive reasoning. This is especially apparent in situations where investors are facing potential losses.

Investors have the tendency to overestimate the probability of unlikely events and underestimate the probability of moderately likely events. (Alexander, et al, 2004). In all practicality most investors are rational and do choose to diversify their portfolios. This brings up the question of how they choose to diversify. There is a theorem that states an investor will choose an optimal portfolio from a set of portfolios that offers maximum expected return for varying levels of risk and offers minimum risk for varying levels of expected return. This set of portfolios is known as the efficient set which is also known as the efficient frontier.

To get the efficient set we have to look at the feasible set first. The feasible set is the set of all available portfolios. Due to the nature of the risk vs. return concept there is a point that is the furthest to the left on the risk axis that is also fairly low on the ex. return axis. The portfolios will populate the figure moving farther to the right as they move higher up the vertical axis.

This creates a curve that connects the portfolio furthest to the left / lowest with the portfolio highest up / furthest right. Therefore, the portfolios that lie on the northwest boundary between these two points meet the conditions to be included in the investors efficient set. Moving one step further the investor can identify an optimal portfolio by combining his indifference curves with the efficient set. The point where the indifference curve and the efficient set curve are tangent to each other gives the investor an optimal portfolio. Remember that risk averse investors prefer the most northwest indifference curve possible. Another practicality that investors face is the prospect of risk free lending and borrowing as a diversification tool for their optimal portfolio.

I will only focus on risk free lending here. When we combine risk free lending with any portfolio then the points representing various proportional combinations can be plotted along a straight line that starts at the risk free rate (100% risk free, 0% portfolio) and ends at the expected return and standard deviation of the portfolio (0% risk free, 100% portfolio). This is important to understand because the now we can have an efficient set that is on a straight line connecting the risk free rate to the most northwest point that we had identified previously. Now the risk averse investor has a lower risk for the same amount of return compared to the portfolios that did not include risk free lending. The combination is better because the points on the straight line are further northwest than the portfolios from the previous paragraph. Of course the lower the level of risk aversion the further toward the tangent the investor's optimal portfolio moves.

In summary, investors on the whole are rational and contribute to an efficient market through prudent investment decisions. Each investor's optimal portfolio will be different depending on the feasible set of portfolios available for investment as well as the indifference curve for that particular investor. Lastly, risk free borrowing and lending changes the efficient set and gives the investor more opportunities to either get a higher expected return with the same amount of risk or the same amount of return with less risk.