Portfolio Theory and the Capital Asset Pricing Model (Capm) Are Essential Tools for Portfolio Managers and Other Stock Market Investors’

Markowitz (1952, 1956) pioneered the development of a quantitative method that takes the diversification benefits of portfolio allocation into account. Modern portfolio theory is the result of his work on portfolio optimization. Ideally, in a mean-variance optimization model, the complete investment opportunity set, i.e. all assets, should be considered simultaneously. However, in practice, most investors distinguish between different asset classes within their portfolio-allocation frameworks.

Investors are always tempted to invest in business opportunities that promise good returns. However, this may drive them gambling tendencies and loss of investment. When savings are seen as appropriate ways of investment accompanied by initial outlays and delight of first results, temptations arise with the call for further re-investments. Investors have critical choices to make at such a point. This is because the accomplishment of the initial investment can characteristically accelerate an appetite for further investment that might expose them to risks. This is an essential stage in the path of any investor and a wise one identifies and effectively navigates this phase (Bery, 2007).

“The Benefits of diversification are clear. Portfolio theory has played a crucial role in explaining the relationship between risk and return where more than one investment is held. It also enables us to identify optimal and efficient portfolios.”

The goal of this paper is to explain why CCM’s aggressive program is a good alternative to any investor looking to diversify its portfolio. The paper will be divided into three distinct parts: the operational analysis, the quantitative analysis and a comparison against its peers (including the impact of CCM in a traditional portfolio).

As for the portfolio, the expected return for a portfolio is the weighted average of the expected rates of return for the individual investments in the portfolio. The variance of the portfolio returns is a weighted sum of the covariance and variance terms associated with the assets in the portfolio. 41 possible portfolios contains DJS and BHP with different weights starting at 100% invested in BHP and increasing the weight at 2.5% intervals until it reaches 100% in DJS.

This provided support for the CAPM and the approach for beta as the only predictor for differences in expected return (Haugen, 1999, p.238-239).

Capital Asset Pricing Model(CAPM) is introduced by Sharpe, Lintner, and Mossin and this model is derived by Markowitz mean-variance model theory. CAPM is applied to investment decision problems. CAPM is also about the understanding of an assets return and also the diversify of risk.

This paper aims to analyze the validity of the CAPM model of predicting returns for stocks by empirically testing the model with past financial data. The CAPM model is defined as R_i=r_f+ β_i (R_m-r_f). R_i represents the return on stock i, and is what the CAPM model attempts to define or predict. r_f represents the risk free rate available at the time the model is being analyzed, a figure that’s important for understanding both minimum return figures and the return premium offered by the market. β_i represents the Beta of stock i and is a measure of a given company’s volatility relative to the market they are in. If β_i is one, then the company is at market risk, if it is lower than one then it is below market risk, and if it is higher than one then it is above market risk. The only stock that would have a Beta of 0 would be a risk free stock, or whatever security you are using for your risk free rate. β_i is calculated as (COVARIANCE(r_i-r_f,〖 r〗_m-r_f))/(VARIANCE(〖 r〗_m-r_f)).(R_m-r_f) represents the Market Risk Premium, or the level of return an average stock in the market would return in excess of the risk free rate.

The bond between risk and return cannot be disregarded due to its significance in business. It is vital to comprehend the correlation between risk and return. Further, knowing how it is affected by time is also paramount (Baker & Riddick, 2013). Investment risk refers to the possibility you may need money investments, or the investments may not probably keep pace with price increases. Notably, all investments are exposed to ascertain the level of risk. However, the level of threat does vary depending on the kind of investment. Investments that carry higher levels of risks are those that have the potential to deliver high investment returns such as the example of growth assets. Investments

Capital Asset Pricing Model (CAPM) was developed in 1964 based on Modern Portfolio Theory. CAMP widely used in investment decisions and financial areas of the company. The main research of CAMP are the relationship between expected rate of return and risk assets in the stock market, as well as how the equilibrium price formation. In terms of the valuation of assets, CAPM primarily used to determine whether the securities market be mispricing. Capital Asset Pricing Model measure risk by non-diversified variance, it linked risk and expected return, any non-diversified risk assets can be described by the value of β, then calculate the expected rate of return. Rate of return required by investors is equals to the discount rate. The limitation of CAPM are: CAPM assumptions inconsistent with the actual; CAPM Should apply only to capital assets, human assets may not be traded; Estimated β coefficient represents the past of variation, but investors are concerned about the security volatility of future price; In the actual situation, the risk-free asset and the market portfolio may not exist.

The concept of portfolio management is a lucrative sword as not only it offers not only returns but the investor also have to face risk associated with it. If the Investor is willing to earn higher return he has to associate higher return with higher risk. For an investor to diversify away the risk he can follow diversification rule. Under diversification, investor can include the assets which are not correlated to each other and thus by including these asset classes he can diversify away the risk. However, in terms of the risk there are two kinds of risk i.e Unsystematic Risk and Systematic Risk and an investor can diversify only unsystematic risk by following diversification rule including the asset classes

So an example is the 20year old gentle man who just started employment who will not depend on his/her investment for income can choose to take higher risks in the quest for very high returns on his investment.

This research paper tends to describe the theory of Capital Asset Pricing Model, which is a theoretical invention much useful for businesspersons and investors who invest with the prevailing risk in the economical environment. The key points of the theory are extracted and highlighted with respect to the explanation of William Sharpe's "A theory of Market Equilibrium under conditions of risk".

In 1959, Markowitz laid a portfolio theory where he introduced mean-variance efficient portfolio that explained minimum variance for given expected return and maximum return for given variance. This revolutionized the finance field and provided groundwork for Capital Asset Pricing Model (CAPM) founded by William F. Sharpe (1964) and John Lintner (1965). Sharpe and Lintner showed that when investors hold mean-variance efficient portfolio and expect homogeneously, then even in absence of market fluctuations the portfolio formed would itself be mean-variance efficient portfolio.

Capital asset pricing model know as CAPM is a model for calculates the required rate of return for any risky asset. This method is often used to determine the fair price of an investment should be. This essay will discuss about usage of CAPM in securities industry, through probe the advantages and limitation of CAPM to this industry.