Portfolio optimization using the efficient frontier and capital market line in Excel
Modern portfolio theory attempts to maximize the expected return of a portfolio for a certain level of risk. The theory is that by diversifying through a portfolio of assets we can get a higher return per unit of risk than we can by holding an individual asset, and that by adjusting the weights of each asset in a portfolio we can create an optimal portfolio for each investor’s level of risk aversion. Assuming that markets are efficient and that the assets in a portfolio aren’t perfectly correlated, we can reduce the total variance of a portfolio at any given expected return by combining assets in various weights.
Imagine a graph with risk on the X axis (measured as standard deviation of the asset’s historical returns) and dividend-adjusted return on the Y axis (measured as an average of historical return). We can plot every possible combination of risky assets in a portfolio to find...
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