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Portfolio Theory and the Capital Asset Pricing Model - Coursework Example

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The paper "Portfolio Theory and the Capital Asset Pricing Model" states that the financial markets have developed to such a degree and complexity, linking with markets across the globe, that the risks of investing one’s hard-earned money require a reliable method…
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Portfolio Theory and the Capital Asset Pricing Model
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Download file to see previous pages A consumer with a certain amount of income is normally confronted with two types of decisions that are of an economic nature.  The first is how to allocate his current consumption among a number of goods and services. A study of how to do this has been the subject of study of many researchers who have developed theories relating costs and utility. The second type of decision concerns how a person with funds not used for consumption could effectively invest these funds among a number of different assets. This second type of decision has not been investigated as thoroughly as the first and continues to be the subject of academic research today. Together, the two types of decisions are known as the consumption-saving decision and the portfolio selection decision.
Of the portfolio selection process, two of the most fundamental and often-used theories that have been developed are the portfolio theory and the capital asset pricing model (CAPM). Both the portfolio theory and the CAPM contain principles that would prove useful to ordinary investors as guidelines in arriving at their own investment decisions (Block & Hirt, 2006). However, much of the theory and its several variations are highly complex and mathematical that they are applied mostly by market professionals rather individual investors because the incremental benefit will only be significant for sizeable portfolio values, sufficient to the effort of undertaking the calculations. Inasmuch as this paper examines the application of these theories for the individual investor, it shall treat on the practical application of the theories’ principles rather than the mathematical derivations thereof, although the basic equations shall be introduced.
According to Scott (2003), the portfolio theory holds that the basis for choosing assets for investment is the manner in which they interact with one another instead of how they perform individually or in isolation. The combination of assets is termed the portfolio. The theory states that an optimal portfolio is one that secures for the investor the least possible level of risk for a given return, or conversely, the highest possible return for a certain given amount of risk. ...Download file to see next pagesRead More
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