Relevance of Portfolio Theory and Capital Asset Pricing Model

In order to lure investors, risky investments must offer greater returns. Actually risk and returns go hand in hand.

It is the belief of investors to distribute their risks and so they diversify their investments as well. They always like to make their investments in a portfolio of assets as they never like to stack all their eggs in one basket. Hence what really matters is not the risk and returns alone, but the risk and return on a portfolio of assets on the whole.

According to James Bradfield (2007, p167), an assortment of securities is known as a portfolio. Portfolio theory is conventional scrutiny of the relationship between risk and return on the risky securities. The rate of returns is particularly measured through alpha, beta, and R-squared. A random variant denotes the rate of return from a portfolio. The computation of the probability distribution generating the returns rate of the security contained in the portfolio depends on the probability distribution creating the value for the portfolio.

The hypothesis is helpful for a patron. It helps them to decide and allocate their funds in risky securities thus creating a portfolio. This investment indicates the preferences with regard to the combination of risk and anticipated returns of the investors.

The CAPM is a link between the risks and returns on the investments. After (Sharpe, William F.1964, pp. 425-442) developed the CAPM theory several other researchers have developed the theory by giving importance to the diversifiable and non-diversifiable risks of different investments. Previously the CAPM had only a single risk factor which was the risk of the entire movement of the market.

“The expected return for an asset I according to CAPM is equal risk-free rate plus a risk premium” (Frank J. Fabozzi and Harry Markowitz, 2002, p.67). Later on, research was conducted and the creators of CAPM theory related diversifiable which are unsystematic risks and non-diversifiable which are systematic risks for all the securities in the portfolio.&nbsp.&nbsp.