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Indifference Curves (Invstments)

Would you please explain these questions:

1. How does the use of indifference curves help determine which portfolio an investor would choose on the efficient frontier? What do the indifference curves implies about an investor's willingness to bear risk?

2. How are the capital market line (CML) and the security market line (SML) different? What does each represent?

The Modern Portfolio Theory allows an investor to place several different investments under one portfolio. This is what is also known as a Diversified Investment Portfolio. In the past, portfolios were limited to one stock only. This did not allow the investor to pick and chose different investments he or she wanted to sell.
MPT allows for diverse stocks to be included in the same portfolio, thus allowing the investor to buy and sell at different times and allows them to decide which stock will show a better rate of return. The indifference cures will show over time which investment is doing better.

The Capitol Market Line (CML) covers the particular rate of return on a single stock and the Security Market Line (SML) covers the rate of return covering the entire market.

Solution Preview

The Modern Portfolio Theory allows an investor to place several different investments under one portfolio. This is what is also known as a Diversified Investment Portfolio.

Investopedia gives the definition of MPT as "A theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward." (www.Investopedia.com/terms/m/modern portfolio theory.) It is good to read the entire portion in Investopedia as it clarifies it even more.

An old cliché would be "Do not put all of your eggs in one basket, save some for a rainy day." This helps optimize your financial stability.

This generic example may give you more insight into the MPT theory: Most people have a checking account, savings, account, Certificate of Deposit, and 401 K and may have an IRA as well. Which of these would you use for the short-term, which one would you reserve for a rainy day and which would choose for long-term investment? Ask yourself which one of the investment products you would liquidate in the midst of a crisis. Would it be the CD or IRA? With investments there are always penalties involved when there are early withdrawals from investment products. Keep in mind that most investment products are not FDIC insured, so there will be a considerable amount of risk involved when investing and selling non FDIC insured products.

MPT allows an investor to have more than one investment product or stock ...

Solution Summary

This article describes the use of indifference curves in the form of graphs in order to determine a cause or non cause of action by an investor. It also covers the description of diverse portfolios.
The investor can use indifference curves (graphs) to determine which investments they may want to pay more attention to.
The article discusses the difference between the Capitol Market line and the Security Market line.

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