A central assumption made in Mean-Variance Analysis and the Capital Essay

A central assumption made in Mean-Variance Analysis and the Capital Asset Pricing Model (CAPM) is that investors prefer to invest in the most efficient portfolios available - Essay Example To determine an efficient portfolio, an efficient frontier is drawn. The efficient frontier is a graph drawn to exhibit different portfolios with a different combination of returns and risks. To achieve such optimal portfolio, there must be a combination of the lowest risk with the highest expected return. The figure below shows the efficient frontier. The efficient frontier has a Y- axis that measures the anticipated rate of return (ER) and X- axis that measures the standard deviation (∞). The curve JKL drawn in the graph is the minimum variance frontier which combines the risk of a portfolio and anticipated return on portfolio to minimize the return deviation at distinct levels of return expected. On the efficient frontier, there are some points that are found either below or above it. Those portfolios that lie below the frontier provide an inadequate return for a given risk hence they are sub-optimal. In other words, they are attainable but insufficient. Conversely, those that lie to the right of the frontier have higher risks given a certain rate of return. In theinvestment of securities, the main objective is to earn returns from a respective investment. High-risk with high returns is always avoided because they require high capital for investment. An investor can anticipate earning a lot from a given security but because of the fluctuations of the market prices and inflation, such investor can incur a loss simply because the future movements of the portfolio cannot be predicted (Fama 2009, p.452). Given an axiom that all investors fear risk, none of them will be willing to invest in a portfolio that has a high possibility of a loss. However, investors prefer a portfolio that has low-risk because they can be certain of the expected returns from a certain portfolio. Though they will not be getting the maximum returns they wish, they are able to get the returns for unforeseen future because