Final answer:
An efficient portfolio offers the highest expected returns for a given level of risk, or the lowest level of risk for a given level of expected returns. Portfolios are considered efficient if there is no alternative with higher returns and lower risk. Diversification helps in achieving efficiency by spreading investment risks. The correct option is a.
Step-by-step explanation:
An efficient portfolio refers to a collection of investments that has the highest expected return for a given level of risk or the lowest risk for a given level of expected return. The correct option indicating when a portfolio is efficient is A) Higher returns and lower risk.
By definition, if no other portfolio offers higher returns with lower risk, then the current portfolio is considered to be on the efficient frontier, a concept from the Modern Portfolio Theory. Diversification is crucial in portfolio management to spread exposure to different investments, potentially reducing the overall risk without sacrificing returns.
Investment portfolios are a balance of risk and returns. Bank accounts, bonds, and stocks represent different levels of this tradeoff, with bank accounts offering low risk and low returns, bonds offering moderate risk and returns, and stocks offering higher potential returns at a higher risk.
The idea is that investors are compensated for the increased risk with higher returns, and no rational investor would invest in riskier assets without the expectation of higher returns.
Hence, an efficient portfolio is said to be one that an investor cannot improve on by either increasing returns without increasing risk or decreasing risk without decreasing returns. The correct option is a.