How to Think Like Benjamin Graham and Invest Like Warren Buffett

(Martin Jones) #1
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ments is not necessarily the weighted sum of the risks (or dispersion
in the returns) of the individual investments.
The central insight of MPT is thus that since variations in re-
turns on individual investments may reduce the dispersion of returns
on a portfolio of investments, portfolio ris kis primarily a function
of the degree of variance of individual investments compared to the
portfolio as a whole. This means that portfolio ris kis minimized
through portfolio diversification.
MPT’s understanding of ris khas another important implication.
With respect to any stock, two elements of risk can be distinguished:
systematic ris kand unsystematic ris k. Systematic ris k(also some-
times called market risk or undiversifiable risk) arises from the ten-
dency of a stoc kto vary as the mar ket in which it is traded varies.
Unsystematic risk (also sometimes called unique risk, residual risk,
specific risk, or diversifiable risk) arises from the peculiarities of the
particular stoc kbeing investigated.
Because under MPT’s diversification directive unsystematic risks
can be diversified away to zero, market returns on a stock in a com-
petitive market will not include any compensation for such risk.
Thus, market returns will be a function solely of the systematic risk,
or the extent to which a particular stoc kvaries as the mar ket of
which it is a part varies. Measuring such ris kand return is the main
goal of capital asset pricing models.


The Capital Asset Pricing Model


As MPT and EMT were maturing in the late 1960s, capital asset
pricing theory was in its infancy. The capital asset pricing model
(CAPM) that is most widely known today derives from MPT (and
was pretty much invented by Markowitz’s co-Nobelist, Sharpe).^16
Like MPT, CAPM assumes that investors are risk-averse in the sense
just described. In addition, CAPM assumes that investors have ra-
tional expectations concerning expected returns. Under this assump-
tion, CAPM says that the expected return on an investment is equal
to the risk-free rate of return plus compensation for the systematic
ris kof the investment in the sense just described.
The systematic ris kis measured by the degree of variability of
the individual investment versus the market as a whole. It relates
the ris kpremium associated with a particular stoc k(its return less
the risk-free return) to that associated with the market as a whole.
That association for any stoc kis expressed by a number called

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