The separation theorem, in finance, asserts that portfolio choice can be divided into two independent tasks: determining the optimal risky portfolio and then choosing the best mix of the risky portfolio and a risk-free asset based on individual preferences. This principle simplifies investment decisions by allowing investors to separate their risk preference from the decision of which risky assets to include in their portfolio.

Separation Theorem

separation theorem

portfolio choice

An optimal risky portfolio is a collection of risky assets that maximizes the Sharpe ratio, providing the best possible return for a given level of risk. It is a crucial component in the Capital Market Line framework, guiding investors on how to combine risky assets with a risk-free asset to achieve the highest expected return for their risk tolerance.

optimal risky portfolio

best mix of the risky portfolio

A risk-free asset is a theoretical investment that guarantees a certain return with zero risk of financial loss. In practice, government bonds from stable economies are often used as a proxy for risk-free assets due to their low default risk and guaranteed interest payments.

risk-free asset

individual preferences

Investment decisions involve selecting assets or projects to allocate resources with the aim of achieving financial returns, taking into account risk tolerance, time horizon, and financial goals. Effective investment decisions require careful analysis of market conditions, asset performance, and alignment with strategic objectives.

investment decisions

risk preference

risky assets

An investment strategy is a systematic plan to allocate assets in a way that aligns with an individual's financial goals, risk tolerance, and time horizon. It involves making informed decisions about which investments to make, how much to invest, and when to adjust the portfolio to optimize returns and manage risk.

CUSTOMIZE YOUR LEARNING

CUSTOMIZE YOUR LEARNING

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