Fig. 6 Capital Market Line.Let us now examine the impact of introducing the risk-free security on the choice of
portfolio by our friends A, B and C. As can be seen from Fig. 6, both A and C have been
able to increase the expected return on their portfolio, by moving to Aā and Cā without
adding to the risk they had assumed earlier. There is no change in the portfolio of B as he
had inadvertently chosen the point of tangency, M as his portfolio even earlier.
Let us now understand the changes that these individuals have made in their portfolios.
To begin with, all of them had invested in a portfolio on the efficient set of risky
portfolio. When risk-free security became available for investment, it was profitable for
A to have a part of his investment in risk-free security and the balance in risky portfolio
M, while it is profitable for C to borrow at the risk-free rate and invest his own capital
plus the borrowed amount in M. as a result of this, A would have what is called a lending
portfolio and C would have a borrowing portfolio. Since individual B had invested in
portfolio M from the beginning, the change in the efficient frontier does not change his
portfolio.
Market Portfolio
Let us now examine the nature of portfolio M in reality. We may argue that if there is a
portfolio represented by point M, it can be identified by many financial analysts in the
market. This is because the exercise thus far was quite straightforward, namely
constructing an efficient set of securities by identifying a large number of risky securities
in the market and by composing several portfolios by mixing them in various proportions,
and so on; altogether an exercise not really beyond the scope of a large computer. If
under such a scenario, the analysts recommended that a particular security, I, be left out
of the portfolio M, everybody who held security I would want to sell it off, so that the
ensuing selling pressure would bring down the price of I so that the return from it would