Optimal Portfolio Selection: A Note
8 Pages Posted: 23 Aug 2000
Date Written: August 8, 2001
Usually in financial textbooks and courses the theory of portfolio selection is taught in a strictly theoretical way. There is a model (Markowitz) that stipulates that an investor has preferences and that she will choose the best portfolio, given her preference curves and an efficient frontier. On the other hand, the Capital Asset Pricing Model (CAPM) is presented as it is: a genial idea that served to simplify and to make operative the Markowitz setup.
Most students and practitioners conclude that those models are just inapplicable theory. This is the most rational behavior one can expect. What can an investor do with the textbook recipes to configure an optimal portfolio? Very little.
My purpose with this note is to rescue a simple procedure presented by Black (1972), Merton (1973) and later by Levy and Sarnat (1982), Elton and Gruber (1995) and Benninga (1997). They just propose that the optimal portfolio can be found maximizing the slope of the line that joins the point of risk-free return and the efficient frontier. When this maximum tangent is reached, that line is the capital market line (CML) (it is tangent to the efficient frontier). This is a simple procedure that does not require one to calculate the efficient frontier and is an easy task with Excel Solver. It is just one point of the efficient frontier. An example is presented.
Keywords CAPM, efficient frontier, porfolio selection, capital market line, optimal portfolio
Notes: This paper is the English version of "Seleccion del Portafolio Optimo: Una Nota"
JEL Classification: G11, G12
Suggested Citation: Suggested Citation