The financial manager plays on a global stage and must comprehend how global financial markets function and how to assess overseas investments (Brealey and Myers, 2003, p.10). This study will address the theoretical justification as well as practical application of portfolio theory and capital asset pricing model with respect to an investor or fund manager.
In order to identify with risk-return trade-off, we view risks of the asset returns of individuals. Risks in individual asset returns have 2 parts - systematic risks and non-systematic risk. Systematic risks are non-diversifiable whereas the non-systematic risks are diversifiable. To eliminate the non-systematic risks, one can form portfolios. Instead of single individual assets, the investors opt for portfolio diversification. The investors’ main concern is about the systematic risks. The return on assets pays off for systematic risks (Jiang, 2003, p. 3).
A little diversification can present a considerable lessening in variability. Suppose one computes and evaluates the standard deviations of arbitrarily selected one-stock or two-stock portfolios. A high percentage of the investments would be in the stocks of small corporations and separately very risky. However, diversification can slash the unpredictability of returns by about fifty percent. Diversification works since prices of various stocks do not move perfectly together (Brealey and Myers, 2003, p.166).
The problem of the investor is to select a portfolio. Let the payoff of his portfolio be ˆX, so its price or value is . He will consume . Thus, his problem is:
The initial wealth constraint is satisfied by the Lagrange multiplier, λ. The investor will invest less in high priced stock and invest more in the low priced stock. Risk aversion, or curvature of the utility function,