1

Feasible set and efficient set.

Given two randomly chosen stocks they will most probably have different expected

returns as well as different standard deviation. The latter represent the statistical properties of

stock returns over a given period of time expressed as the probability of deviations from the

mean. In our case the mean is the average return expected. We can interpret it as the risk that the

expected return will not materialize. The curve that plots the expected returns and standard

deviation for all possible mixes of the two chosen stocks is called the feasible set.

While the variance of a portfolio of any two-asset depends on the weight invested in each

asset, the variance of each asset and the covariance between the two assets the volatility of the

portfolio depends on the latter factor, or correlation coefficient in its standardized measure. By

plotting expected returns and standard deviation of two randomly chosen assets we will have

neither a perfect positive nor a perfect negative correlation but, most probably, an intermediate

case (Smart et al., 2007). With two arbitrarily chosen assets the plot will be an arc connecting the

two points represented by a portfolio of only one stock, let’s say stock A with lower expected

return and a lower standard deviation, with a portfolio of only the other stock, let’s say stock B.

While diversification reduces unsystematic risk the arc firstly bends up and backward to the

y-axis representing expected returns while volatility or standard deviation decreases even if

expected returns increases. This up to a certain point while subsequently the arc bends on the

opposite direction to the point represented by only the stock B with higher expected returns and

also the highest volatility. The point where the arc inverts the direction is called the MVP

(minimum variance portfolio) and represents the mix with the lowest standard deviation but

nevertheless with a higher expected return than a portfolio with only stock A. We can therefore
 2

deduce that a mix of the two stocks up to the MVP realizes a lower volatility than either stock A

or B and higher returns than a portfolio of only stock A. Moreover while we could accept a

higher risk (standard deviation) we are able to achieve a higher expected return by increasing the

portion of stock B. Hence any portfolio mix on the arc from the MVP to point B offers the

highest expected return among portfolios with equal or less volatility (Smart et al., 2007). The

efficient set is the upward sloping part of the curve that represents the best relation between

expected returns and standard deviation.