Describe how adding a risk-free security to modern portfolio theory allows investors to do better than the efficient frontier.

Answer 1

The best portfolios investors can hold with only risky assets are the efficient portfolios on the efficient frontier. If investors can borrow and lend at a risk-free rate, then they can do better. To improve over the efficient frontier, investors should allocate their portfolio to the risk-free rate and to the market portfolio. With the right weights between the two, an investor can find a portfolio with the same level of risk as an efficient portfolio but has a higher expected return.