WHAT IS AN EFFICIENT
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An efficient (or
optimal) portfolio consists of
investments in a variety of asset classes selected for minimum
correlation in order to lower portfolio volatility.
Examples of asset classes include cash, bonds, and stocks. Each
asset class has differing degrees of volatility. The number of
assets in a portfolio is not as important as the relationship
among those assets. Modern Portfolio Theory looks at portfolios
as a whole rather than focusing on the performance of individual
Efficient portfolios have the highest returns for the lowest
possible volatility. To select an efficient portfolio, you choose
one from the efficient frontier that matches your risk tolerance.
You should keep in mind, however, that in general, the lower the
volatility, the lower the potential return.
Modern Portfolio Theory assumes that investors dislike risk.
They will make investment decisions based on maximizing their
returns for an acceptable level of risk.
Now let's look at some of the pluses and
minuses of an efficient portfolio.