How do you use the efficient frontier and the capital market line to select the optimal portfolio?

1 What is the efficient frontier?

The efficient frontier is a graphical representation of the trade-off between risk and return for a set of possible portfolios. It shows the highest expected return for a given level of risk, or the lowest risk for a given level of return. The efficient frontier is curved because of the diversification effect, which means that combining different assets can reduce the overall risk of the portfolio. The portfolios on the efficient frontier are called efficient portfolios, and they are the best choices for rational investors.

4 How to find the market portfolio?

The market portfolio is not easy to find in practice, because it requires knowing the market values and expected returns of all the risky assets in the market. However, one way to approximate the market portfolio is to use a broad-based index fund that tracks the performance of a large and representative segment of the market, such as the S&P 500 index fund. An index fund is a type of mutual fund that invests in a basket of securities that mimic the composition and returns of a specific index. By investing in an index fund, you can achieve a high degree of diversification and exposure to the market.

5 How to adjust the CML for personal factors?

The CML assumes that all investors have the same expectations and preferences regarding the risk and return of the market portfolio. However, this may not be true in reality, as different investors may have different personal factors that affect their investment decisions, such as their income, wealth, age, tax status, and goals. Therefore, to select the optimal portfolio that suits your individual needs, you may need to adjust the CML for your personal factors. For example, you may need to consider your tax rate when choosing between taxable and tax-exempt securities, or your time horizon when choosing between short-term and long-term investments.

6 How to use the CML to evaluate individual securities?

The CML can also be used to evaluate individual securities and determine whether they are overpriced or underpriced relative to the market. To do this, you need to compare the expected return and standard deviation of the security with those of a portfolio that lies on the CML and has the same level of risk. If the security offers a higher return than the portfolio, it is underpriced and attractive to buy. If the security offers a lower return than the portfolio, it is overpriced and unattractive to buy. This method is based on the assumption that the security is fully diversified and has no unsystematic risk, which is the risk that is specific to the security and can be eliminated by diversification.