Portfolio Theory with Capital Asset Pricing Model. Do they work hand in hand or is Portfolio Theory better on it's own?

Portfolio Theory with Capital Asset Pricing Model. Do they work hand in hand or is Portfolio Theory better on it's own?

There are several academics that have different opinions on how investors should choose their investments. Some investors choose their investments based on the idea that the larger the risk the larger the expected returns, whereas others choose to accept a smaller return for a less risky project. For example, a young entrepreneur who is not dependent on income from investment may choose a more risky investment; whereas someone older who depends on the income could possible choose something less risky with more certain and stable returns. However, is it possible to find an optimum point whereby you can receive the maximum gains for a specific level of risk?

Harry Markowitz certainly thought so when he introduced the portfolio theory. The thinking behind his theory was that any unexpected bad news with one firm would be compensated by unexpected good news from another (Arnold, 2013) therefore you are reducing risk by not putting all of your eggs in one basket. With Markowitz’ portfolio theory he suggested an investor could find the optimum portfolio of investments and therefore could find the ‘efficient frontier’.

What is the efficient frontier?

According to Markowitz the efficient frontier is the optimal point that offers the highest expected return for a specific level of risk given the volatility they are willing to accept (Investopedia). Alternatively it can be looked at as the lowest risk for an expected level of return. The theory takes into consideration the risk of the investment and what returns can potentially be made from it.

(Watson & Head, 2013)

To explain in more detail, point A, E and F are the more efficient points for a diversified portfolio. Point G means that they are receiving smaller returns for the level of risk than they could at point E. Therefore from point A – G this would be classed as being inefficient, and likewise anything in the blue area and below would also be classed as being inefficient. This theory also suggests that anything above the efficient frontier is impossible.

Adding the Capital Asset Pricing Model Line…

When the Capital Asset Pricing Model (CAPM) is included the optimal portfolio can then be found. It can be applied to decide investment in the financial markets for portfolio selection. It also calculates the required rate of return on an investment project which therefore works alongside portfolio theory.

As viewed above, when the CAPM line is calculated and applied alongside the efficient frontier it provides an optimum point whereby the portfolio is at its most efficient. However, although portfolio theory has much credibility, there are a few limitations to the CAPM which are highly controversial. Firstly, this method only looks at one period, therefore needing to be recalculated for any others (therefore making it extremely time consuming). Additionally CAPM requires the use of Beta to calculate the line – a highly controversial topic surrounding Beta is whether it is valid for determining future decisions when Beta is based on past events.

Overall…

The overall theory of the portfolio theory model appears to be credible with a clear underlining formula stating what is efficient and what is inefficient. It takes into consideration different investors and what would be optimal for their level of risk. However, the underlying formula is complicating and time consuming so therefore there is some difficulty in implementing the model. Furthermore there is more difficultly in attempting to calculate the CAPM line with more controversial topics surrounding this.

Overall it appears that when calculated correctly both of the theories work well together in finding the optimum point for an overall portfolio. However, when taking into consideration the different types of investors and the levels of risk they would be willing to take, the portfolio theory on it’s own appears to be a better model to follow.

References

Arnold, G (2013). 'Valuing Shares'. In: Corporate Financial Management. 5th ed. Great Britain: Pearson.

Investopedia (2015). Efficient Frontier. [ONLINE] Available at: http://www.investopedia.com/terms/e/efficientfrontier.asp. [Last Accessed 03/12/2014].

Watson,D and Head, A, (2013). 'Mergers and Takeovers '. In: Corporate Finance Principles and Practice. 6th ed. United Kingdom: Pearson.