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Unit-29: Insurance Choice and Risk

Notes
Fig. 29.5

E R
Expected rate of return R Efficiency M K F

Frontier
N

E
O
r r
1 2
Standard Deviation (Risk)

The Optimal Portfolio
In efficient frontier, the investor will opt that portfolio in which risk return preference is higher utility
from various possible portfolios. Because risk averse investor thinks expected returns “good” and risk
(σ) as “bad”. His preference indicates by indifference curve from various portfolios. To determine the
efficient frontier, these indifference curves determine which efficient portfolio he selects. That is optimal
or best portfolio.
Figure 29.6 shows three indifference curves I , I and I . The upward slope from left to right indicates
1
3
2
risk covered exchange. Curve I shows more preference than curve I and curve I shows more than
1
3
2
curve I . EF is efficient frontier. P is optimal portfolio point where curve EF touches curve I . Point A is
2
2
also on I curve. But this is not the point of optimal portfolio because it is outside the efficient frontier.
2
Again point B on I curve is not optimal portfolio because this gives preference of minimum risk to
1
investor. Thus P is optimal portfolio because it is on the tangent point of maximum risk preference I
2
curve and efficient frontier EF.
Fig. 29.6
Expected rate of return Optimal B I P 3 I 2 I 1 F
Protfolio

A

E
O
Standard Deviation (Risk)

Risk Reduction through Portfolio Diversification

An investor can reduce his risk of investment in stock market by risk diversification. The meaning of
diversification is to expand his investment into two or more than two assets or shares. This is like “not

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