Efficient Frontier, CML, SML, RISK

EFFICIENT FRONTIER/CML/SML/RISK
What is an Efficient Frontier?

The efficient frontier is the set of optimal portfolios that offers the highest
expected return for a defined level of risk or the lowest risk for a given level of
expected return. Portfolios that lie below the efficient frontier are sub-optimal
because they do not provide enough return for the level of risk. Portfolios that
cluster to the right of the efficient frontier are also sub-optimal because they have
a higher level of risk for the defined rate of return.
BREAKING DOWN Efficient Frontier

A key finding of the concept was the benefit of diversification resulting from the
curvature of the efficient frontier. Optimal portfolios that comprise the efficient frontier
tend to have a higher degree of diversification than the sub-optimal ones, which are
typically less diversified. The efficient frontier concept was introduced by Nobel
Laureate Harry Markowitz in 1952 and is a cornerstone of modern portfolio theory.
Optimal Portfolio
One assumption in investing is that a higher degree of risk means a higher potential
return. Conversely, investors who take on a low degree of risk have a low potential
return. According to Markowitz's theory, there is an optimal portfolio that could be
designed with a perfect balance between risk and return. The optimal portfolio does not
simply include securities with the highest potential returns or low-risk securities. The
optimal portfolio aims to balance securities with the greatest potential returns with an
acceptable degree of risk or securities with the lowest degree of risk for a given level of
potential return. The points on the plot of risk versus expected returns where optimal
portfolios lie are known as the efficient frontier.
Selecting Investments
Assume a risk-seeking investor uses the efficient frontier to select investments.
The investor would select securities that lie on the right end of the efficient
frontier. The right end of the efficient frontier includes securities that are expected
to have a high degree of risk coupled with high potential returns, which is suitable
for highly risk-tolerant investors. Conversely, securities that lie on the left end of
the efficient frontier would be suitable for risk-averse investors.
Modern Portfolio Theory (MPT).
Modern Portfolio Theory (MPT), a hypothesis put forth by Harry Markowitz in his paper
"Portfolio Selection," (published in 1952 by the Journal of Finance) is an investment theory
based on the idea that risk-averse investors can construct portfolios to optimize or maximize
expected return based on a given level of market risk, emphasizing that risk is an inherent part of
higher reward. It is one of the most important and influential economic theories dealing
with finance and investment.
Also called "portfolio theory" or "portfolio management theory," MPT suggests that it is possible
to construct an "efficient frontier" of optimal portfolios, offering the maximum possible expected
return for a given level of risk. It suggests that it is not enough to look at the expected risk and
return of one particular stock. By investing in more than one stock, an investor can reap the
benefits of diversification, particularly a reduction in the riskiness of the portfolio. MPT
quantifies the benefits of diversification, also known as not putting all of your eggs in one basket.
Assumptions and Limitations of modern portfolio theory/ efficient frontier

The efficient frontier and modern portfolio theory have many assumptions that may not
properly represent reality. For example,
One of the assumptions is that asset returns follow a normal distribution. In reality,
securities may experience returns that are more than three standard deviations away from
the mean in more than 0.03% of the observed values. Consequently, asset returns are said
to follow a leptokurtic distribution or heavy-tailed distribution.
Additionally, Markowitz's posits several assumptions in his theory, such as:
Investors are rational and avoid risk when possible.
There are no enough investors to influence market prices.
And investors have unlimited access to borrowing and lending money at the risk-
free interest rate.
However, reality proves that the market includes irrational and risk-seeking investors,
there are large market participants who could influence market prices, and there are
investors who do not have unlimited access to borrowing and lending money.
Capital Allocation Line – CAL/CML.
What is the Capital Allocation Line – C.A.L.
The capital allocation line (CAL), also known as the capital market line (CML), is a line
created on a graph of all possible combinations of risk-free and risky assets. The graph
displays to investors the return they might possibly earn by assuming a certain level of
risk with their investment. The slope of the CAL is known as the reward-to-variability
ratio.
The capital allocation line aids investors in choosing how much to invest in a risk-free
asset and one or more risky assets. Asset allocation is the allotment of funds across
different types of assets with varying expected risk and return levels, whereas capital
allocation is the allotment of funds between risk-free assets, such as certain Treasury
securities, and risky assets, such as equities.
Security market line (SML)
Security market line (SML) is the representation of the capital asset pricing model. It displays the expected rate of
return of an individual security as a function of systematic or non-diversifiable risk.[1] The risk of an individual
risky security reflects the volatility of the return from security rather than the return of the market portfolio. The risk
in these individual risky securities reflects the systematic risk.
Where
E(Ri) is an expected return on security
E(RM) is an expected return on market portfolio M
β is a non-diversifiable or systematic risk
RM is a market rate of return
Rf is a risk-free rate
When used in portfolio management, the SML represents the investment's opportunity cost investing in a
combination of the market portfolio and the risk-free asset). All the correctly priced securities are plotted on the
SML. The assets above the line are undervalued because for a given amount of risk (beta), they yield a higher return.
The assets below the line are overvalued because for a given amount of risk, they yield a lower return.
There is a question about what the SML looks like when beta is negative. A rational investor will accept these assets
even though they yield sub-risk-free returns, because they will provide "recession insurance" as part of a well-
diversified portfolio. Therefore, the SML continues in a straight line whether beta is positive or negative. A different
way of thinking about this is that the absolute value of beta represents the amount of risk associated with the asset,
while the sign explains when the risk occurs.
Difference between CML and SML.

1. The CML is a line that is used to show the rates of return, which depends on risk-free rates
of return and levels of risk for a specific portfolio. SML, which is also called a Characteristic
Line, is a graphical representation of the market’s risk and return at a given time.
2. While standard deviation is the measure of risk in CML, Beta coefficient determines the
risk factors of the SML.
3. While the Capital Market Line graphs define efficient portfolios, the Security Market Line
graphs define both efficient and non-efficient portfolios.
4. The Capital Market Line is considered to be superior when measuring the risk factors.
5. Where the market portfolio and risk free assets are determined by the CML, all security
factors are determined by the SML.
SYSTEMATIC AND UNSYSTEMATIC RISK

Systematic risk is the probability of a loss associated with the entire market or the segment
whereas Unsystematic risk is associated with a specific industry, segment or security. ...
Conversely, unsystematic risk can be eliminated through diversification of portfolio.
Where:
N represents number of securities in a portfolio
Sigma represents Total risk (variability of the portfolio)
COMPARISON CHART.
BASIS FOR
SYSTEMATIC RISK UNSYSTEMATIC RISK
COMPARISON
Meaning Systematic risk refers to the Unsystematic risk refers to

hazard which is associated the risk associated with a
with the market or market particular security, company
segment as a whole. or industry.
Nature Uncontrollable Controllable
Factors External factors Internal factors
Affects Large number of securities Only particular company.

in the market.
Types Interest risk, market risk Business risk and financial

and purchasing power risk. risk
Protection Asset allocation Portfolio diversification

Efficient Frontier, CML, SML, RISK

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EFFICIENT FRONTIER/CML/SML/RISK

What is an Efficient Frontier?

BREAKING DOWN Efficient Frontier

Assumptions and Limitations of modern portfolio theory/ efficient frontier

Additionally, Markowitz's posits several assumptions in his theory, such as:

Investors are rational and avoid risk when possible.

There are no enough investors to influence market prices.

Difference between CML and SML.

SYSTEMATIC AND UNSYSTEMATIC RISK

N represents number of securities in a portfolio

Sigma represents Total risk (variability of the portfolio)

Meaning Systematic risk refers to the Unsystematic risk refers to

Nature Uncontrollable Controllable

Factors External factors Internal factors

Affects Large number of securities Only particular company.

Types Interest risk, market risk Business risk and financial

Protection Asset allocation Portfolio diversification

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