Risk-free securities are investments whose returns carry no risks over a specified period. Investors tend to use the modern portfolio theory to determine the investments that generate maximum returns within a certain level of risk. Adding risk-free security to the modern portfolio theory is a safe investment because investors do not expect losses (Parkinson, 2020). With modern portfolio theory, risk-averse investors can design a portfolio that enables them to analyze the level of risks of the available investment options and determine the combination of investments that carry little or no risks (Parkinson, 2020). This theory is a form of diversification such that it allows investors to mix various investments within a portfolio to manage risks.
Investments can be risky with high returns or less risky with low returns. The main objective of the modern portfolio theory is to minimize losses and maximize returns. On the contrary, the efficient frontier model offers optimal portfolios with the highest expected returns for a certain risk level or the lowest returns for the lowest risks. This model does not allow investors to assess their tolerance to risk, thus misguiding investors who are high risk-takers likely to suffer losses (Parkinson, 2020). Therefore, investors who use the modern portfolio theory are likely to perform better than those who use the efficient frontier model because the modern portfolio manages risks better than the efficient frontier model.
The market risk premium refers to the return that the investor expects from investing in a risky market above the risk-free rate assets. This premium tends to vary by either increasing or decreasing over time depending on the market’s volatility (Escobari & Jafarinejad, 2019). These changes affect the desire of people to buy stocks. The market risk premium increases when the volatility is high and decreases when the volatility is low. Therefore people may buy stocks when the market risk premiums are high to expect higher returns at greater risks.
References
Escobari, D., & Jafarinejad, M. (2019). Investors’ uncertainty and stock market risk. Journal of Behavioral Finance, 20(3), 304-315.
Parkinson, C. S. (2020). Maximizing Returns for Investors Using Modern Portfolio Theory and the Efficient Frontier.