Chapter 7 • Portfolio theory and its relevance to real investment decisions
Figure 7.5
The risk /return
profiles of various
portfolios of
securities A, B, C,
D and E
Each point along any of the solid curved lines represents the risk and return of a portfolio
containing some proportion of some of the securities. The curve that passes through points X
and Y represents the risk and return of a portfolio containing some proportion of allof the
securities. The portfolios that lie along this line between B and X are said to dominate all
other possible combinations of these five securities. This means that they have either a
higher expected return for the same (or a lower) level of risk, or lower risk for the same
(or a higher) expected return.the expected risk/return profile of a portfolio containing various proportions of each
of these five securities. Note that every combination of expected return and risk along
this line ‘dominates’ any other position in which the investor could be with these five
securities. Take point X along this line, for example. No other combination available
will either yield higher expected return for X’s level of risk, or has less risk for X’s
expected return. Consider the portfolio represented by point Y: although this has a
higher expected return than X, it also has higher risk. Thus X does not dominate Y, nor
does Y dominate X.Efficiency
Of course, the five securities in Figure 7.5 neither represent the total of financial invest-
ment opportunities nor, therefore, the maximum specific risk reduction opportunities
available. There is an efficient frontier for securities as a whole. This is represented in
Figure 7.6. Each point on the line EE represents some portfolio constructed from some