6. Summary

In this section, we have extended the concept of diversification to a world with more than two assets. To do so, we have chosen a two-step approach:

 

  • First, we have optimized the portfolio choice within the universe of risky assets. The result was the so-called efficient frontier, which summarizes the portfolios of risky assets that generate the highest possible return at a given amount of risk.
     
  • Second, we have combined risky portfolios with the risk-free asset. We have seen that one portfolio on the efficient frontier becomes relevant, the so-called Market Portfolio. Combining this market portfolio with the risk-free asset gives the best possible risk-return trade-off. This linear combination is called the Capital Market Line (CML).

 

In essence, these are the foundations of "Modern Portfolio Theory". 

   

While we have covered a lot of ground so far, we are not quite there yet. Remember that we started out with the ambition to estimate discount rates. This is something we have not done yet. By now, we understand how risk and return are related and what investors can do to diversify the risk of individual assets. 

  

This knowledge will be crucial for the next step, where we build the bridge between portfolio theory and discount rates.