Question

Why is risk tolerance important in considering portfolio design? How does it interface with desired returns of the investor as we construct an “efficient” portfolio? Include the “efficient frontier” in your discussion.

Answer 1

Risk tolerance is very important in consideration of the portfolio design because investors should always be knowing the ability of himself in order to deal with risk in the market so that he can make the desired return.

There are various types of investor based upon the risk taking ability. there will always be risk averse investor and there will always be risk loving investors.

The risk lovers, will always be trying to take more risk in order to maximize their overall rate of return, and the risk averse investor will be trying to take no risk, and they will be sticking to the market rate of return and risk free rate of return.

It is helpful in creation of an efficient portfolio because it is demonstrated by efficient Frontier that such portfolio should be constructed where the overall risk of the portfolio should be minimised and the overall return of the portfolio should be maximized so the principle of efficient portfolio would be focusing on maximization of the rate of return of Investor by minimization of the risk, so it will help the investor to to create Alpha.