28 ATaleofTwoMarkets
parent underreaction to information, and the likelihood of abnormal
returns continuing after an event are about as likely as those returns
reversing after that event.
Thus, a whole group of leading economists thinks that the latest
evidence against EMT does not add up to much. They cling to in-
vestment tools that are based on EMT and used to complete the
theoretical picture with practical applications.
TIDYING UP THE TALE
EMT tells us that specified information sets are fully reflected in
the price of public securities. EMT, however, does not provide any
basis for determining what it means for any such information to be
fully reflected in stoc kprices. Doing this requires a theory of asset
pricing. It is composed of two popular ideas: modern portfolio theory,
which provides the foundation, and the capital asset pricing model,
which is the general paradigm.
Modern Portfolio Theory
While the random wal kmodel and EMT were being developed in
the 1950s and 1960s, Harry Markowitz of the City University of New
Yor kand yet another Nobel Prize recipient (in 1990, along with
Sharpe) was developing modern portfolio theory (MPT).^15 The basic
idea here is that combining a group of noncorrelated stocks in a
single portfolio results in a portfolio with less volatility than the av-
erage volatility of those individual stocks.
MPT proposes that all investments are reducible to two ele-
ments—ris kand return—and assumes that investors are ris k-averse
in the sense that they will sacrifice returns to avoid ris kand demand
greater returns to assume risk. MPT says that such investors will
best address their ris kaversion by investing in a portfolio of invest-
ments in which they receive the greatest expected return for any
given level of risk.
The expected return on an investment is simply the weighted
average of all possible returns on it, and the ris kof an investment
is the dispersion of possible returns on that investment around the
expected return. Under MPT, expected return on a portfolio of in-
vestments is simply the weighted sum of the expected returns on the
individual investments; the risk, however, of a portfolio of invest-