1. Introduction

The preceding section has introduced the basics of diversification in a world with only two assets (U.S. stocks and bonds). To what extent risk can be diversified primarily depends on the correlation between the assets in question. 

  

The logical next step is to extend these considerations and look at a world with more than two assets. That's the purpose of this section:

 

  • First, we generalized the basics of diversification and search for portfolios with multiple risky assets that offer the highest possible return for a given level of risk. The resulting set of portfolios of risky assets is called the Efficient Frontier.
     
  • Second, we investigate how we can combine a risky asset with a risk free asset and what the resulting investment opportunities look like.
     
  • Third, we bring these two elements together and discuss how to optimally invest if we have the efficient frontier of risky portfolios and the risk-free asset. The result is the so-called Capital Market Line (CML). It identifies the portfolios with the best possible risk and return characteristics.

 

It is important to note that this section is rather theoretical. However, the topics we discuss here are absolutely crucial, as they build the foundation of what is generally referred to as "Modern Portfolio Theory." The good news is that we derive the necessary concepts and conclusions with a set of rather simple graphs. So there is only very little math involved…