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"A central assumption made in Mean-Variance Analysis and the Capital Asset Pricing Model (CAPM) is that investors prefer to invest in the most efficient portfolios available"
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An efficient portfolio is a collection of investments that provide the highest expected return at the given level of risk or portfolio that yield the lowest risk at given expected a return. Expected return is the minimum return expected by investors investing in any given asset. The risk occurs due to deviation from the expected return in either case as explained by Markowitz. According to Markowitz Portfolio Theory, individuals who accept to take high return with high-risk cannon diversify further without acceptance of greater risk. On the other hand, individuals will not agree to reduce their return without reduction of risk. This fact explains why low-risk, low-return and high-risk, high-return portfolios are equivalent when it comes to investing. Markowitz (1952: 77) believes that portfolio choice is dependent on maximum discounted risk venture which will give a high return since the future is uncertain and assurance of money back on investment should be assured.
The low-risk, low-return investors motivated by low risk in an asset they are investing in will invest more getting quantifiable income. On the other hand, high risk – high return individuals will tend to invest in minimal assets with high risk, but getting a quantifiable return due to their nature of the high return. As argued by Markowitz (1952, p, 77) investors should not just go for high return high-risk investment rather they should focus on the expected return. An investor may go for high-risk, high return bonds, but in case of failure, the return will be greatly reduced. On the other hand, an investor may go for several low-risk, low-return, but the cumulative expected return will be high (hypothesis of the maxim by Markowitz 1952: 78.).
According to maxim hypothesis, both diversified and under-diversified assert will have the same cumulative expected return. In the United States, the under-diversified portfolio is greater among young people,
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There is a famous saying that one should not place all the eggs in one basket. The concept of portfolio also came from this saying which means that one should not make all the investment in one asset or security and should diversify the investment by investing in a group of assets so that the loss from one security can be compensated by the gain of the other security.
The theory encompasses the construction of a portfolio which can minimize the risk and at the same time maintains the required return for the investor (Markowitz, 1991). Construction of such a portfolio which has the aforementioned characteristics can be possible through diversification.
This paper will outline how this method of valuing an asset fits to be a factor pricing model. This will entail discussing the assumptions relating to the form of stochastic discount model as well as how the factor method is related to the acquiring of equilibrium risk premium.
The CAPM model therefore relies on the ability to measure market volatility as a whole. With several possible investments available in the market, the model assumes that one can accurately assess the volatility of each of these investments. This is impossible.
The idea of investing in the financial market is to purchase the asset while the price is low, and to sell when the price appreciates.
The seeming arbitrary movement of prices of assets, such as stocks, has
The risk free rate is the government bond ideally, that has a fix ten years. The Beta is the true measure of the risk that is in the stock that one has invested on.
With the risk in it, measure the volatility of the investment. It is in this
hout a significant decrease in returns, and the need to select the most profitable portfolios, the importance and correctness of CAPM is often questioned. This paper examines the importance and correctness of the model by drawing from various financial concepts and
Normally, they devote their due care on the average and deviation of their returns from the investment to minimize the deviation of the return on the portfolio given an anticipated return and maximize anticipated
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