The investment opportunity set is examined in detail in readings on investments, but it is appropriate to examine it briefly here because we are learning about constraints on behavior. Consider possible investments in which one option might be to invest in an essentially risk-free asset, such as a US Treasury bill. There is virtually no possibility that the US government would default on a 90-day obligation to pay back an investor’s purchase price, plus interest. Alternatively, an investor could put her money into a broadly diversified index of common shares. This investment will necessarily be more risky because of the fact that share prices fluctuate. If investors inherently find risk distasteful, then they will be reluctant to invest in a risky asset unless they expect to receive, on average, a higher rate of return. Hence, it is reasonable to expect that a broadly diversified index of common shares will have an expected return that exceeds that of the risk-free asset, or else no one would hold that portfolio.

Our hypothetical investor could choose to put some of her funds in the risk-free asset and the rest in the common shares index. For each additional dollar invested in the common shares index, she can expect to receive a higher return, though not with certainty; so, she is exposing herself to more risk in the pursuit of a higher return. We can structure her investment opportunities as a frontier that shows the highest expected return consistent with any given level of risk, as shown in Exhibit 10. The investor’s choice of a portfolio on the frontier will depend on her level of risk aversion.

Note: The investment opportunity frontier shows that as the investor chooses to invest a greater proportion of assets in the market portfolio, she can expect a higher return but also higher risk.