This post continues the Modern Portfolio Theory - Part 1.
Remember from last time:
- Assume investments have random returns that follow a normal distribution.
- You must invest all your money, but by wisely choosing your portfolio, you could create a portfolio of a variety of different average returns and variability (standard deviation).
- A rational investor would only choose to create a portfolio that minimized variability for any given level of return. These portfolios are on the efficient frontier.
- The blue dots are also on the efficient frontier technically (minimum variance for a given level of return) but not very interesting, as a rational investor could choose to get both more return and less variance.
One thing we didn't mention was the possibility of holding cash. Let's see what introducing this possibility does to our graph.