Question

Please consider all that we have learned thus far regarding the impact of diversification, risk-free securities, and market premiums. With that in mind, please describe how adding a risk-free security to modern portfolio theory allows investors to do better than the efficient frontier. Additionally, explain how might the magnitude of the market risk premium impact people's desire to buy stocks?

Answer 1

how adding a risk-free security to modern portfolio theory allows investors to do better than the efficient frontier.

A security which is free of the various possible sources of risk. One is the risk that the debtor may default; this is thought to be absent in the case of UK, US, and many other countries' government debt

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 – chief among them, a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, or not putting all of your eggs in one basket.

The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any one of the individual stocks, provided the risks of the various stocks are not directly related. Consider a portfolio that holds two risky stocks: one that pays off when it rains and another that pays off when it doesn't rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio.

For every level of return, there is one portfolio that offers the lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These combinations can be plotted on a graph, and the resulting line is the efficient frontier

Any portfolio that lies on the upper part of the curve is efficient: It gives the maximum expected return for a given level of risk. A rational investor will only ever hold a portfolio that lies somewhere on the efficient frontier. The maximum level of risk that the investor will take on determines the position of the portfolio on the line.

Modern portfolio theory takes this idea even further. It suggests that combining a stock portfolio that sits on the efficient frontier with a risk-free asset, the purchase of which is funded by borrowing, can actually increase returns beyond the efficient frontier. In other words, if you were to borrow to acquire a risk-free stock, then the remaining stock portfolio could have a riskier profile and, therefore, a higher return than you might otherwise choose.

explain how might the magnitude of the market risk premium impact people's desire to buy stocks

The market risk premium is the difference between the expected return on a market portfolio and the risk-free rate. The market risk premium is equal to the slope of the security market line (SML), a graphical representation of the capital asset pricing model (CAPM).

Investors require compensation for risk and opportunity cost. The risk-free rate is a theoretical interest rate that would be paid by an investment with zero risks and long-term yields on U.S. Treasuries have traditionally been used as a proxy for the risk-free rate because of the low default risk. Treasuries have historically had relatively low yields as a result of this assumed reliability. Equity market returns are based on expected returns on a broad benchmark index such as the Standard & Poor's 500 index of the Dow Jones industrial average.

Real equity returns fluctuate with the operational performance of the underlying business, and the market pricing for these securities reflects this fact. Historical return rates have fluctuated as the economy matures and endures cycles, but conventional knowledge has generally estimated a long-term potential of approximately 8% annually. Investors demand a premium on their equity investment return relative to lower risk alternatives because their capital is more jeopardized, which leads to the equity risk premium.The market risk premium is a forward-looking tool and should always be positive. ... high level of risk aversion would only be willing to buy stocks with low risk. Therefore, the magnitude of the risk premium does impact who wants to buy stocks.