Efficient Frontier and Portfolio Construction Assumptions

A

Statement 1: "Investors believe all investments are represented by a probability distribution of expected returns."

This statement is correct. One of the assumptions underlying the use of the efficient frontier is that investors believe all investments can be characterized by a probability distribution of expected returns. This means that investors assign probabilities to different outcomes or scenarios and estimate the expected return associated with each outcome. By combining these expected returns with the associated probabilities, investors can determine the overall expected return for a particular investment.

The efficient frontier is a graphical representation of the set of optimal portfolios that provide the highest expected return for a given level of risk or the lowest level of risk for a given expected return. In order to construct this frontier, investors need to make assumptions about the expected returns of various assets. They typically use historical data, financial models, and market information to estimate the expected returns and associated probabilities for different investments.

Statement 2: "Investors base investment decisions solely on the expected risk of the investment."

This statement is incorrect. While risk is an important factor in investment decision-making, investors do not base their decisions solely on the expected risk of an investment. In addition to risk, investors also consider expected returns, liquidity, diversification, market conditions, investment objectives, time horizon, and other factors.

The concept of the efficient frontier recognizes the trade-off between risk and return. Investors aim to maximize their expected return for a given level of risk or minimize their risk for a given expected return. The efficient frontier helps investors identify the optimal combination of assets that achieves this trade-off.

Therefore, the correct answer is A. Only Statement 1 is correct. Statement 2 is incorrect because investors consider factors beyond just the expected risk of an investment when making investment decisions.