Question

Describe Tobin’s Separation Theorem and its improvements to Markowitz portfolio theory.

What addition did Tobin make to the universe of possible assets?

Did Tobin conclude that all clients have a customized portfolio or that the best ideas are appropriate for all investors?

Do you believe that one size fits all or that each investor should have a customized portfolio or some combination? Why?

How did the risk-free asset improve portfolio theory?

Answer 1

Markowitz portfolio theory suggested that it is possible to construct an efficient frontier of optimal portfolios which will maximize the expected return for a given level of risk. Tobin introduced the concept of risk free assets and suggested that most investors will choose a combination of risk free asset and the optimal portfolio. It is known as the Separation theorem as it made improvements to Markowitz theory and separated it from the completely different decision of dividing the portfolio between risk free and risky assets.

Tobin concluded that all investors have their own customized portfolio as the liquidity preferences and risk appetite are not the same for the investors. Based on their preference they can choose how to allocate the resources between the optimal portfolio that is the one with the highest return per unit of risk and the risk free asset. Investors have different proportion of risk free assets.

Each investor should have a customized portfolio as per his risk appetite and liquidity needs and all investors can never have the same preferences. Depending on the age and financial goals one should choose his customized portfolio.

The risk free asset improved portfolio theory as in the practical world all investors have a need for liquidity and many of them are risk averse. They prefer to avoid risk and thus invest in risk free assets. Markowitz portfolio was far from the reality which assumed that all investors will invest only in risky assets. Thus the optimal portfolio is the combination of risky and risk free assets.