Risk-return Spectrum - Domination

Domination

All investment types compete against each other, even though they are on different positions on the risk-return spectrum. Any of the mid-range investments can have their performances simulated by a portfolio consisting of a risk-free component and the highest-risk component. This principle, called the separation property, is a crucial feature of Modern Portfolio Theory. The line is then called the capital market line.

If at any time there is an investment that has a higher Sharpe Ratio than another then that return is said to dominate. When there are two or more investments above the spectrum line, then the one with the highest Sharpe Ratio is the most dominant one, even if the risk and return on that particular investment is lower than another. If every mid-range return falls below the spectrum line, this means that the highest-risk investment has the highest Sharpe Ratio and so dominates over all others.

If at any time there is an investment that dominates then funds will tend to be withdrawn from all others and be redirected to that dominating investment. This action will lower the return on that investment and raise it on others. The withdrawal and redirection of capital ceases when all returns are at the levels appropriate for the degrees of risk and commensurate with the opportunity cost arising from competition with the other investment types on the spectrum, which means they all tend to end up having the same Sharpe Ratio.

Read more about this topic:  Risk-return Spectrum

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Famous quotes containing the word domination:

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    Ronald Reagan (b. 1911)

    Man is more disposed to domination than freedom; and a structure of dominion not only gladdens the eye of the master who rears and protects it, but even its servants are uplifted by the thought that they are members of a whole, which rises high above the life and strength of single generations.
    Karl Wilhelm Von Humboldt (1767–1835)

    There is no Soviet domination of Eastern Europe and there never will be under a Ford administration.... The United States does not concede that those countries are under the domination of the Soviet Union.
    Gerald R. Ford (b. 1913)