Question # 2753
(easy)With prior experience in the financial industry and a graduate education in finance and risk, you are familiar with Markowitz’s Efficient Frontier theory. Now, as the portfolio manager for a state government agency known for its risk-averse approach, you face a new challenge. Due to recent budget cuts, you’ve persuaded the executive team to consider launching new programs and projects that can demonstrate tangible benefits to the state.
To support this initiative, you apply the principles of the Efficient Frontier to illustrate the current state of the agency’s portfolio in terms of risk and associated costs. You explain that a portfolio is considered efficient if it provides:
Answers:
a. A mix of components—from high risk / high return to low risk / low return.
b. The ability to quantify the value of risk in monetary terms.
c. The possible overall portfolio value with the greatest possible benefits.
d. The best possible expected level of return for its level of risk.
Explanation and reference
The Standard for Portfolio Management – 4th Edition, 7.4, 7.5, 7.6: The correct answer is D.
This is correct because it aligns with the concept of the Efficient Frontier in Modern Portfolio Theory. This theory identifies portfolios that provide the maximum expected return for a given level of risk. It ensures that for every level of risk, the portfolio is optimized to yield the best possible return, which is the essence of being "efficient" in portfolio management.
The concept is crucial in portfolio management as it helps in identifying the most efficient allocation of assets, balancing between risk and return. This optimization allows portfolio managers to make informed decisions that maximize returns while managing potential risks effectively.
Why Other Options Are Incorrect:
A: While a mix of components from high risk/high return to low risk/low return can be part of a diversified portfolio, it does not specifically relate to the definition of an "efficient" portfolio in the context of the Efficient Frontier.
B: Quantifying risk in monetary terms is part of risk management but does not define portfolio efficiency according to the Efficient Frontier theory.
C: While overall portfolio value and benefits are important, the Efficient Frontier specifically addresses the balance between expected return and risk, not just maximizing possible benefits.
Therefore, option D is the most accurate representation of an efficient portfolio as per the Efficient Frontier in portfolio management.
This is correct because it aligns with the concept of the Efficient Frontier in Modern Portfolio Theory. This theory identifies portfolios that provide the maximum expected return for a given level of risk. It ensures that for every level of risk, the portfolio is optimized to yield the best possible return, which is the essence of being "efficient" in portfolio management.
The concept is crucial in portfolio management as it helps in identifying the most efficient allocation of assets, balancing between risk and return. This optimization allows portfolio managers to make informed decisions that maximize returns while managing potential risks effectively.
Why Other Options Are Incorrect:
A: While a mix of components from high risk/high return to low risk/low return can be part of a diversified portfolio, it does not specifically relate to the definition of an "efficient" portfolio in the context of the Efficient Frontier.
B: Quantifying risk in monetary terms is part of risk management but does not define portfolio efficiency according to the Efficient Frontier theory.
C: While overall portfolio value and benefits are important, the Efficient Frontier specifically addresses the balance between expected return and risk, not just maximizing possible benefits.
Therefore, option D is the most accurate representation of an efficient portfolio as per the Efficient Frontier in portfolio management.
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