Portfolio Selection

The objective of every rational investor is to maximize his returns and minimize the risk. Diversification is the method adopted for reducing risk. It essentially results in the construction of portfolios. The proper goal of portfolio construction would be to generate a portfolio that provides the highest return and the lowest risk. Such a portfolio would be known as the optimal portfolio. The process of finding the optimal portfolio is described as portfolio selection.

Feasible set of portfolios: With a limited number of securities an investor can create a very large number of portfolios by combining these securities in different proportions. These constitute the feasible set of portfolios in which the investor can possibly invest. This is also known as the portfolio opportunity set. Each portfolio in the opportunity set is characterized by an expected return and a measure of risk, viz., variance or standard deviation of returns. Not every portfolio in the portfolio opportunity set is of interest to an investor. In the opportunity set some portfolios will obviously be dominated by others. A portfolio will dominate another if it has either a lower standard deviation and the same expected return as the other, or a higher expected return and the same standard deviation as the other. Portfolios that are dominated by other portfolios are known as inefficient portfolios. An investor would not be interested in all the portfolios in the opportunity set. He would be interested only in the efficient portfolios.

Efficient set of portfolios:

Let us consider various combinations of securities and designate them as portfolios 1 to n. The expected returns of these portfolios may be worked out. The risk of these portfolios may be estimated by measuring the standard deviation of portfolio returns. The table below shows illustrative figures for the expected returns and standard deviations of some portfolios.

Selection of optimal portfolio: The portfolio selection problem is really the process of delineating the efficient portfolios and then selecting the best portfolio from the set. Rational investors will obviously prefer to invest in the efficient portfolios. The particular portfolio that an individual investor will select from the efficient frontier will depend on that investor‘s degree of aversion to risk. A highly risk averse investor will hold a portfolio on the lower left hand segment of the efficient frontier, while an investor who is not too risk averse will hold one on the upper portion of the efficient frontier. The selection of the optimal portfolio thus depends on the investor‘s risk aversion, or conversely on his risk tolerance.

This can be graphically represented through a series of risk return utility curves or indifference curves. The indifference curves of an investor are shown in the figure below. Each curve represents different combinations of risk and return all of which are equally satisfactory to the concerned investor. The investor is indifferent between the successive points in the curve. Each successive curve moving upwards to the left represents a higher level of satisfaction or utility. The investor‘s goal would be to maximise his utility by moving upto the higher utility curve. The optimal portfolio for an investor would be the one at the point of tangency between the efficient frontier and the risk-return utility or indifference curve.

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