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At the core of Modern Portfolio Theory (MPT) is a set of critical principles for analyzing and choosing the optimal portfolio components to achieve the best risk-reward ratio. An investment portfolio is a set of several investment objects, which is managed as an independent investment object to achieve the set goal. Achieving high profitability with minimal risk is the task of various methods for finding the most profitable investments.
In the theory of forming the best portfolio, a risk-free asset is a security that offers an entirely predictable rate of return in the monetary units selected for analysis. Since risk-free security has covariance, an indicator of the variability of portfolio or stock returns equal to zero guarantees specific stability, which cannot be said about the efficient frontier in MPT. (Adjei, 2020, p. 58) The effective frontier represents a particular market analysis and implies a percentage deviation; with such a level of risk, periodic drawdowns are likely, which is not the best investment option.
The magnitude of the market risk premium impacts peoples desire to buy stocks to a large extent. The opportunity to earn more from more risky portfolios involves more investments, as a consequence, more risk. Risks involve the theoretical possibility of operating at a loss and losing all funds. What is more, people have a lot of fears concerning investments with the market risk premium. People may worry that stocks will fall in value, and the investor will sell them cheaper than he bought and incur losses. Perhaps the company will go bankrupt, and in this case, the investor will lose all invested funds. Stocks failing to sell is also a common fear for risky investments.
Reference
Adjei, F. (2020). Effect of economic policy uncertainty on market risk and market risk premium. Journal of Finance and Economics, 8(2), 57-60. Web.
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