Domination
All investment types compete against each other, even though they are on different positions on the risk-return spectrum. Any of the mid-range investments can have their performances simulated by a portfolio consisting of a risk-free component and the highest-risk component. This principle, called the separation property, is a crucial feature of Modern Portfolio Theory. The line is then called the capital market line.
If at any time there is an investment that has a higher Sharpe Ratio than another then that return is said to dominate. When there are two or more investments above the spectrum line, then the one with the highest Sharpe Ratio is the most dominant one, even if the risk and return on that particular investment is lower than another. If every mid-range return falls below the spectrum line, this means that the highest-risk investment has the highest Sharpe Ratio and so dominates over all others.
If at any time there is an investment that dominates then funds will tend to be withdrawn from all others and be redirected to that dominating investment. This action will lower the return on that investment and raise it on others. The withdrawal and redirection of capital ceases when all returns are at the levels appropriate for the degrees of risk and commensurate with the opportunity cost arising from competition with the other investment types on the spectrum, which means they all tend to end up having the same Sharpe Ratio.
Read more about this topic: Risk-return Spectrum
Famous quotes containing the word domination:
“The will to domination is a ravenous beast. There are never enough warm bodies to satiate its monstrous hunger. Once alive, this beast grows and grows, feeding on all the life around it, scouring the earth to find new sources of nourishment. This beast lives in each man who battens on female servitude.”
—Andrea Dworkin (b. 1946)
“Physical nature lies at our feet shackled with a hundred chains. What of the control of human nature? Do not point to the triumphs of psychiatry, social services or the war against crime. Domination of human nature can only mean the domination of every man by himself.”
—Johan Huizinga (1872–1945)
“There is no Soviet domination of Eastern Europe and there never will be under a Ford administration.... The United States does not concede that those countries are under the domination of the Soviet Union.”
—Gerald R. Ford (b. 1913)