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Intermediate
Indifference Curve is a term used in portfolio theory to describe investor demand for portfolios based on the trade-off between expected return and risk. It is a convex curve, meaning upward curving and where it meets the Efficient Frontier there is a match between supply and demand. This spot is called the Optimal Portfolio.
Synonyms: indifference function, utility curve, risk tolerance, utility function
For context, recall that there is a wide gap between what scholars hypothesize about how markets work and how investors actually behave. Case in point is the topic of indifference curves. Modern Portfolio Theory itself assumes that investors actually go through the process of calculating expected returns and covariances for all available assets to arrive at expected risk, measured by portfolio standard deviation.
When you look at the news media surrounding equity markets it is clear that retail investors make a lot of random decisions based on much less forethought and analysis than scholars. So it's particularly important to understand the theory behind portfolio choice for those interested in building a consistent and repeatable investment process. It's helpful for passing a portfolio theory exam too.
Mia: Doc, if Harry Markowitz invented MPT, why
is Warren Buffet more famous?
Doc: Warren, like most practitioners, figured
out that talking about theory shifts the client indifference curve
away from investing.
This video can be accessed in a new window or App , at the YouTube Channel or from below.
Indifference curve definition for investment modeling (4:44)
The script includes two sections where we visualize and demonstrate the indifference curve.
We're sitting in Excel and this is a snippet from our boot camp course.
There we cover all of the curves, lines and dots shown here in one 40-minute video, but because most people don't have that much time, we have eleven separate 4-5 minute videos like this one. I'll provide a link to the boot camp video number 22 at the end if you'd like the whole story.
Ok, let's keep it simple and focus on the Indifference Curve, which is part of Modern Portfolio Theory, developed by Harry Markowitz in the 1950s.
First of all, we have a chart, with expected return on the y-axis and expected risk on the x-axis. Here we are using the expected timeframe, which uses past observations as input, then after making adjustments, you have what is baked-in to market expectations. Of course there is a lot to setting expectations, and that is the focus of the boot camp.
Now, the Indifference Curve, also called a Utility Curve, is the light green curve here. It represents one investor's tolerance for risk at different levels of expected return.
And here we have what is supplied by the market, meaning millions of portfolios invested in all risky assets around the world, with the most viabile portfolios along the top edge along the Efficient Frontier.
So this is a very theoretical concept and only institutional investors with their portfolio optimization programs go through this, and even then, quantifying risk tolerance is difficult, if not impossible. Also, for academic theories to work, scholars include a list of assumptions, meaning holding other variables constant. And here is a list of assumptions to review later.
Let's demonstrate this by talking about two points on the indifference curve while thinking about the word indifference. Here, the client would require a higher rate of return to accept this higher level of risk. Because these curves don't cross there is no match between supply and demand.
And as we slide down the curve, to another spot where the investor would be indifferent, or accept equally, a lower return with this lower level of risk. Oh look, the market supply, or portfolios offered by the market here match what the investor is willing to accept, so there is a match between supply and demand. This is the point called the Optimal Portfolio.
Keep in mind that a risk-averse investor, like a retiree, may have a curve way above this one. They'd be less willing to accept market risk.
Click box for answer.
True
False. It is a demand curve.
Still unclear on the indifference curve? Leave a question in the comments section on YouTube or check out our Quant 101 series, specifically the tutorial called Ace Your Portfolio Theory Exam.
Our trained humans found other terms in the category modern portfolio theory you may find helpful.
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