In real life, equilibrium is a constantly moving target. We cannot say that the stock market is in equilibrium at the end of the day or week or year. Prices move based on the perception of brokers and shareholders, driven by information (Fama, 1970), psychology (Kahneman and Tversky, 1982), or anything under the sun (Barberis, Shleifer, and Vishny, 1998). As investors try to maximise returns or minimise losses, they either push up or pull down stock prices, or keep it level, the differences between the demand of buyers and the supply of sellers being reflected in stock price changes.
This is equilibrium, which is not a static point but more of a dynamic process where adjustments constantly take place, reflecting the free agreement of investors in the market that stocks are bought and sold at the right price. Of course, one side thinks the price will go up, while the other side thinks it will go down. By 'assuming' equilibrium as an ideal state towards which everything moves, finance academics have discovered a tool that allows them to pin down a moving target - the behaviour of stock prices over the last fifty years, for example - so they can study it, test their theories, develop a mathematical model, and see if the model explains reality.
One such aspect of reality that is being studied for the last half a century is the relationship between the return of a stock price and the risk that the return will not be realised. Several years of observations have made academics ask: how should investors decide which stocks to buy
This is what Markowitz did in his paper (Markowitz, 1952), where he drew attention to the practice of portfolio diversification. After observing that stock prices move differently in relation to the general movement of the stock market, he showed that investors could reduce the unpredictability of returns by investing in a mixture or portfolio of stocks whose prices do not move exactly in the same way. When stock market prices are rising, some stock prices rise with it while some go the opposite way, and not at the same rates.
Markowitz measured these stock price movements using a statistical tool called 'standard deviation', which indicates how far a stock price has moved from its average value. His first observation was that the higher the standard deviation, the higher the average, or expected, return. This looks like common sense, because a stock A whose price swings from 2 to 10 per share surely promises a higher return than a stock B whose price swings from 4 to 8 even if both have an "average" price of 6. Conversely, such large price swings also promise a bigger loss if the investor bought stock B at the wrong time.
One of Markowitz's insights is that every investor wants to get the highest expected return (r) for a given standard deviation (), so he suggested that investors put their money in what he called an efficient portfolio. Using historical stock prices, he determined that different stocks have different values of and r. Next, he computed what would happen if he mixed stocks and discovered that one could get a higher