How does an investor earn more than the return generated by the tangency portfolio and still stay on the security market line?
a. Borrow at the risk free rate and invest in the tangency portfolio.
b. Add high risk/return assets to the portfolio.
c. Adjust the weight of stock in the portfolio to include more high return stocks.
d. It cannot be done.
The correct answer is option B: Add high risk/return assets to the portfolio.
To understand how an investor can earn more than the return generated by the tangency portfolio and still stay on the security market line, let's break down the components of this question.
The tangency portfolio refers to the optimal portfolio that arises from combining the risky assets available in the market with the risk-free asset. It represents the highest expected return for a given level of risk or volatility.
The security market line (SML) is a graphical representation of the Capital Asset Pricing Model (CAPM), which shows the expected return of an asset as a function of its systematic risk (beta). The SML depicts the relationship between expected returns and systematic risk, with the slope of the line indicating the excess return that investors demand for taking on additional risk.
To earn more than the return generated by the tangency portfolio and still stay on the SML, the investor can add high risk/return assets to the portfolio. By incorporating assets with higher expected returns into the investment mix, the investor can potentially increase the overall return of the portfolio while maintaining the same level of risk as defined by the SML.
Options A and C are not valid because they do not necessarily allow the investor to earn more than the return generated by the tangency portfolio. Borrowing funds at the risk-free rate and investing solely in the tangency portfolio does not increase the overall return beyond what is already available in the market. Similarly, adjusting the weight of stocks in the portfolio to include more high-return stocks may increase the return on those specific stocks but does not guarantee an overall return higher than that generated by the tangency portfolio.
Option D is incorrect because, as mentioned earlier, adding high risk/return assets to the portfolio can potentially help earn more than the return generated by the tangency portfolio while staying on the SML.
Therefore, the correct answer is option B: Add high risk/return assets to the portfolio.