Portfolio Selection 🎯🔝
After months of analyzing returns, calculating risks, and plotting the Efficient Frontier, the investor finally reaches the most important question: Which specific portfolio should I buy? This is the stage of Portfolio Selection.
1. The Two-Step Process
Modern Portfolio Theory breaks down investment into two distinct steps:
- Investment Analysis: Finding the Efficient Frontier (The same for ALL investors).
- Portfolio Selection: Choosing one point on that frontier that fits your personal Risk Tolerance (Unique to EACH investor).
2. Risk Tolerance and Utility
Why does one person choose a 100% stock portfolio while another chooses 100% bonds? It depends on their Utility Function.
- Risk-Averse Investors: They value safety more than high returns. They will select a point on the lower-left end of the Efficient Frontier.
- Risk-Seeking Investors: They are willing to endure huge price swings for a chance at high growth. They will select a point on the upper-right end of the Efficient Frontier.
There is no single "Best" portfolio for everyone. The Optimal Portfolio is simply the one that provides the highest possible satisfaction (Utility) for a specific individual.
3. The Tangency Point
In later chapters, we will learn that when we add a "Risk-Free Asset" (like Govt Bonds) to the mix, the selection process changes. Every investor will hold a mix of the same "Market Portfolio" and the Risk-Free asset. This is a key part of the Capital Market Line (CML).
Summary
- Portfolio Selection is the final decision in the investment process.
- It combines objective math (The Frontier) with subjective preference (Risk Tolerance).
- The goal is to maximize the investor's Utility.
- We move from finding "What is Efficient" to finding "What is Optimal."
Quiz Time! 🎯
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