The separation principle states that an investor will:
A)choose between any efficient portfolio and a riskless asset to generate the desired expected return.
B)choose a portfolio from the efficient set based on individual risk tolerance.
C)never choose to invest in a riskless asset due to the low expected rate of return.
D)combine a riskless asset with the tangency portfolio based on their risk tolerance level.
E)combine a riskless asset with the minimum variance portfolio based on their risk tolerance level.

Question

Quizplus · Accepted Answer

The separation principle states that investors can separate their investment decisions into two parts: 1) determination of the optimal risky portfolio based on individual risk tolerance and 2) combination of the risky portfolio with a riskless asset to achieve the desired expected return. Option D is correct, as it suggests that the investor combines a riskless asset with the tangency portfolio based on their risk tolerance level. The tangency portfolio is the efficient portfolio that has the highest Sharpe ratio, i.e., the highest reward for a given level of risk.

The Separation Principle States That an Investor Will