Concept of Dominance 🏰🛡️
Out of the millions of possible portfolios an investor can build, most are actually a waste of time. The Concept of Dominance is a logical "filter" used to remove inefficient portfolios and focus only on the best ones.
1. What is Dominance?
In finance, we say Portfolio A Dominates Portfolio B if:
- Same Risk, Higher Return: Both have 10% risk, but A gives 15% return while B gives 12%. (A is better).
- Same Return, Lower Risk: Both give 15% return, but A has 10% risk while B has 12% risk. (A is better).
- Higher Return AND Lower Risk: A is better in both dimensions.
A rational, risk-averse investor will NEVER choose a dominated portfolio. They will always discard dominated options in favor of the dominators.
2. The Dominance Matrix
| Portfolio | Expected Return | Standard Deviation (Risk) | Status |
|---|---|---|---|
| X | 12% | 8% | Efficient |
| Y | 12% | 10% | Dominated by X (Same return, more risk) |
| Z | 14% | 8% | Dominates X (More return, same risk) |
In this table, Portfolio Z is the clear winner because it offers the highest return for the lowest risk level (8%).
3. From Dominance to the Efficient Frontier
Once we apply the dominance filter to all possible portfolios, we are left with a small group of "winners." None of these winners dominate each other.
- One might have low risk and low return.
- Another might have high risk and high return.
Connecting these non-dominated portfolios on a graph gives us the Efficient Frontier.
Summary
- The Dominance Principle helps in eliminating inefficient investment choices.
- A portfolio is efficient if it is not dominated by any other portfolio.
- Investors always seek the "Maximum Return for Minimum Risk."
- Dominance is the logic that builds the Efficient Frontier.
Quiz Time! 🎯
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