Chapter 7 • Portfolio theory and its relevance to real investment decisions
Mean/variance criterion
lMaking certain assumptions, all that needs to be known about an investment
is its expected value of returns and how those returns array around that
expected value.Diversification
lDiversification can eliminate specific risk but not systematic risk. In practice:
lvery little diversification (just two or three different investments with equal
values of each investment) can lead to large risk reduction;
lonce the portfolio consists of 15 to 20 different investments there is little
scope for further risk reduction.
lWith sufficient diversification, an ‘efficient’ portfolio is formed, that is, one
with no specific risk.
lWithout a borrowing/lending opportunity, individuals will have different
efficient frontier preferences, depending on their utility for wealth.Capital asset pricing model (CAPM)
lIf there is a borrowing/lending opportunity at a ‘risk-free’ rate, all indivi-
duals will have the same preference as to location on the efficient frontier.
lIndividuals will achieve their maximum utility through borrowing or lending.
lCAPM says that the expected return from a risky investment is equal to the
risk-free rate (rf) plus a risk premium.
lThe CAPM risk premium equals the average risk premium for all risky assets
(the expected level of return for all risky assets (rm), less the risk-free rate (rf))
multiplied by the riskiness of the particular asset concerned relative to the
average level of risk (β).
lCAPM concerns itself only with systematic risk, that is, it says that there are
no rewards (in terms of enhanced returns) for bearing specific risk. This is lo-
gical because the latter can be avoided by diversification.
lIt is reasonable to look to the risk/return profiles of stock market equities and
to use this to determine discount rates for risky projects because- the stock market is a free and efficient market where the prices of assets
with known risk/return profiles can be observed; - for shareholder-wealth-enhancing businesses, it is through the market price
that this goal will substantially be achieved.
lDespite its theoretical logic, CAPM has been consistently demonstrated, over
recent times, to be seriously deficient in assessing risk and indicating the
appropriate required rate of return for bearing risk.
lAccording to survey results, CAPM is widely used in practice by businesses
to derive discount rates, particularly for an investment of a type that the busi-
ness does not usually make, by looking at the betas of businesses that spe-
cialise in that type of investment.