Explain why the best portfolio should not contain any money...

Explain why the best portfolio should not contain any money (use information from Section D of this chapter). How does the notion of the cost of holding money fit into your answer? Would your answer change if your checking account earned a return equal to that of risk-free investments?

Key Concepts

Opportunity Cost

Opportunity cost refers to the potential gains an investor misses out on when choosing one option over another. In the context of portfolio management, holding money (cash) typically yields very little return compared to other investments. This lost potential from not allocating funds to higher-return assets is central to why the best portfolio should minimize cash holdings.

Cost of Holding Money

The cost of holding money involves the forgone returns that could have been earned if that money were invested in more productive assets. Although holding cash provides liquidity, it comes with the trade-off of missing out on earnings from risk-free or other investments. This cost is a key factor in portfolio construction decisions, influencing investors to limit cash to the minimal required for liquidity purposes.

Portfolio Optimization

Portfolio optimization is the process of balancing risk and return to achieve the best possible performance. Including non-earning cash in a portfolio can dilute overall returns without providing a compensatory reduction in risk. Therefore, in an optimized portfolio, money is not held unnecessarily since its low return does not justify its presence against more lucrative investment opportunities.

Risk-Free Return Considerations

The risk-free return represents the return available on investments with negligible risk, such as government bonds. If a checking account were to earn a return equal to risk-free investments, holding cash would be less costly in terms of forgone returns. However, even with comparable returns, the role of money in the portfolio remains limited because its primary function is liquidity, and resources are typically allocated directly to risk-free assets to maximize overall portfolio efficiency.

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