Selection of Optimal Portfolio 🎯💎
Now that we have the Efficient Set (the red curve on the graph), we need to pick exactly one portfolio. This specific portfolio is called the Optimal Portfolio.
1. Indifference Curves
Every investor has a mental "map" of how much return they need to compensate for taking more risk. This is represented by Indifference Curves.
- A "Flat" curve: Belongs to a risk-taking investor. They don't mind extra risk.
- A "Steep" curve: Belongs to a risk-averse investor. They demand a huge increase in return for even a tiny increase in risk.
2. The Tangency Condition
The Optimal Portfolio is found at the point where the Efficient Frontier is Tangent (touches) the highest possible Indifference Curve of the investor.
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3. Why the Tangency Point?
- Feasibility: It must be on the frontier (otherwise it's inefficient).
- Utility: It must be on the highest possible indifference curve (highest satisfaction).
Key Insight
Because every investor has different indifference curves (attitudes toward risk), the "Optimal Portfolio" will be different for everyone.
- An old retiree might pick an optimal portfolio at the bottom-left.
- A young aggressive trader might pick one at the top-right.
Summary
- The Optimal Portfolio is unique to each investor.
- It is found where the investor's Utility is maximized.
- Mathematically, it's the Tangency Point between the Efficient Frontier and the Indifference Curve.
- It marks the end of the Markowitz portfolio selection process.
Quiz Time! 🎯
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