I think its that optimal portfolio is the Rf + the Optimal Risky Portfolio. Where the optimal risky portfolio is a combination of the market portfolio and an active portfolio?
Yes I think you are right. With no active portfolio the optminal risky portfolio is the market portfolio (or tangency portfolio is we assume heterogenous expectations).
Okay if this is the case, can you explain separation theorem. It says all investors should ghold a combo of the RF and the Market. Which Schweser says is called the optimal risky portfolio, independent of the ivnestors risk aversion.
You’re on schweser and I understand where you are, I just recently took this test too and though the wording was BS.
Separation theorum separates the investors tolerance for risk and the choice of which risky assets to invest in. Think of it with the treynor black, you have your passive portfolio and you can increase the return and hopefully maintain your risk aversion by optimally allocating to an active portfolio that has more individually risky assets but you don’t know WHAT assets are there. This is what the portfolio manager is working for, the alpha.
I know I haven’t answered the question perfectly but I feel that this general level of understanding can mitigate your confusion come test day as I hope it will for me.
Right but wouldn’t investor risk play into which assets to put into the active portfolio?
I think yes if the PM could NOT manage the TOTAL risk with a combination of the Risky assets and a Risk Free treasury. Since the PM can do this he can minimize the total risk by identifying securities with high alpha and low UNsystematic risk, put them in the optimal risky portoflio, then find the optimal portfolio by adjusting for the concentration of 1) the optimal risky portfolio and 2) the risk free rate. It’s like taking 5% of the portfolio and investing in high risk micro-caps, 95% in stable large caps, and then if the total risk is too high he then lends at the risk free rate for some of the portfolio to limit the total risk. This, in theory, allows a PM to choose whatever specific small-cap stocks he believes will generate the highest IR for the active part of the portfolio without calling the investor every day saying, “hey I have this idea that’s suitable to your portfolio, but I just want to run it by you first and let you understand what’s going on here…”
It’s theory so I hate to sum up my comments by saying just go with it, but just go with it. You may care as a CFA candidate but some people who don’t understand what a stock is won’t.