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Portfolio Theory and the Capital Asset Pricing Model (CAPM)

Portfolio Theory and the Capital Asset Pricing Model (CAPM)

Relevance of Portfolio theory to an Investor or Fund Manager

The basic idea behind the Modern Theory Portfolio is that the 'set' or 'universe' of securities representing the investment choice faced by an individual behaves differently to each other. If, for example, the price of oil rises significantly then oil firms (for whom stocks will immediately be worth considerably more and whose margins may rise) will tend to offer better returns than firms for whom oil is a significant cost factor(Phillips, 2007). Portfolio theory identifies the Investor's Investment Goals, Objectives, Preferences, Constraints and Strategy Guidelines that are designed to meet the objectives, while staying within the boundaries imposed by the constraints preferences (Lettau, 2001). Once an Investment Policy is decided upon, it should be made EXPLICIT by putting it in written form. According to Portfolio Theory, the preference order on a set of gambles is mediated by two variables; (1) the expected value (EV) and (2) the perceived riskiness of each of the gambles (Kiefer, 2000). Furthermore, whenever a set of gambles are equal in EV, then the preference order on these gambles is single-peaked over the risk order. That is, if we have three gambles, A, B, and C for which

EV (A) = EV (B) = EV(C),

In the above formula, we know the first component (the risk-free rate) represents the

Minimum compensation an investor can expect to receive (or it represents a guaranteed

Return) (Kiefer, 2000). The second component measures the difference between the expected return of the risky asset and a risk-free asset, which represents the additional compensation the

Investor needs in order to take on those additional risks.

We will begin by looking at a portfolio in the simplest investment environment where there are only two types of asset available: a risky asset and a risk-free asset (Kiefer, 2000). In other words, when an investor decides to put together a portfolio, those are the only two types of assets available.

Suppose an investor is putting together a portfolio that contains both types of assets: so proportion of the portfolio is made up of the risky asset and (1- w) is made up of risk-free asset. As a result, the return of the portfolio (p R) is defined as follows:

P r rf R = w× R + (1- w) × R

Where = r R return of the risky asset

= rf R return of the risk-free asset, i.e. the risk-free rate

The theory says that By investing in more than one stock, an investor can reap the benefits of diversification - chief among them, a reduction in the riskiness of the portfolio (Kiefer, 2005). For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, it is the deviation from the average return. Each stock has its own standard deviation from the mean, which MPT calls ...

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