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IAI Actuarial Core Principles · Economic Modelling · Capital Asset Pricing Model (CAPM)

Which assumption is required for investors to select portfolios purely on the basis of mean and variance of return?

Mean-variance selection is justified when asset returns are normally distributed or when investors have quadratic utility, since then the mean and variance fully describe the relevant features of the return distribution. Risk neutrality would make variance irrelevant.

  1. AReturns are normally distributed, or investors have quadratic utilityCorrect
  2. BInvestors are risk-neutral
  3. CAll assets are uncorrelated
  4. DInvestors have an infinite time horizon with no taxes on any asset
  5. The risk-free rate equals the market return

Explanation

Mean-variance choice is fully consistent with expected utility if returns are multivariate normal or utility is quadratic. Risk-neutral investors would ignore variance. Zero correlation is not needed, as diversification works for any correlation below one.

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