Unit 5 Discussion: Impact of Risk-free Rates and Market Premiums

Please consider all that we have learned thus far regarding the impact of diversification, risk-free securities, and market premiums. With that in mind, please describe how adding a risk-free security to modern portfolio theory allows investors to do better than the efficient frontier. Additionally, explain how might the magnitude of the market risk premium impact people's desire to buy stocks?

Modern Portfolio Theory (MPT) argues that it's possible to design an ideal portfolio that will provide the investor maximum returns by taking on the optimal amount of risk. MPT advocates diversification of securities and asset classes or the benefits of not putting all your eggs in one basket. MPT says stocks face both systematic risk—market risks such as interest rates and recessions—as well as unsystematic risk—issues that are specific to each stock, such as management changes or poor sales. Proper diversification of a portfolio can't prevent systematic risk, but it can dampen, if not eliminate, unsystematic risk.

The best portfolios investors can hold with only risky assets are the efficient portfolios on the efficient frontier. If investors can borrow and lend at the risk fee rate, then they can do better. To improve over the efficient frontier, investors should allocate their portfolio on the risk free rate and to the market portfolio.

Everybody has a different level of Risk aversion. People who have a low level of risk aversion would be willing to buy stocks with high risk and people who have a high level of risk aversion would only be willing to buy stocks with low risk. Therefore, the magnitude of the market risk premium does impact who wants to buy stocks.