The above equation evaluates the return on a risky asset in terms of (a) its minimum compensation and (b) its potential risk compensation. Within the thinking on modern portfolio theory, the Capital Asset Pricing Model (CAPM) establishes the theoretical relationship between risk and return, where average expected investor return is determined by the average market return, as shown below:
β represents market sensitivity. An investor can, hence, estimate returns (r) by understanding β, the risk inherent in the stock, when only the stock’s history is considered. In a well diversified portfolio, though, the volatility of the individual stock has little influence on the portfolio’s overall performance. Empirical data gathered in investigations of CAPM, however, argues against the predictions of the model and this has largely invalidated many applications of the model.
Portfolio Theory is focused on investors. Two fundamental choices have to be made: what proportion of risky assets should be included in the portfolio; and asset allocation, which depends on the conservative or aggressive requirements of the investor.
The theory of diversification allows lower standard deviations and variances of returns within a portfolio. Additionally, the Efficient Market Hypothesis (EMH) suggests that the prices of assets fully reflect available information: the implication is that the market cannot be consistently outperformed, since future share prices cannot be predicted based on historical data (weak-form efficiency); share prices adjust immediately to all available information (semi-strong-form efficiency); share prices reflect public and private information (strong-form efficiency).
Diversification suggests two subsequent approaches to the management of the portfolio: active management requires the selection of stocks and the timing of the market, whereas passive management requires the purchase and long-term