Review of the Capital Asset Pricing Model
1. Investors like high expected return and low standard deviation. Common stock portfolios that offer the highest expected return for a given standard deviation are known as efficient portfolios.
2. If the investor can lend or borrow at the risk-free rate of interest, one efficient portfolio is better than all the others: the portfolio that offers the highest ratio of risk premium to standard deviation. A risk-averse investor will put part of his money in this efficient portfolio and part in the risk-free asset. A risk-tolerant investor may put all her money in this portfolio or she may borrow and put in even more.
3. The composition of this best efficient portfolio depends on the investor’s assessments of expected returns, standard deviations, and correlations. But suppose everybody has the same information and the same assessments. If there is no superior information, each investor should hold the same portfolio as everybody else; in other words, everyone should hold the market portfolio
4. Don’t look at the risk of a stock in isolation but at its contribution to portfolio risk. This contribution depends on the stock’s sensitivity to changes in the value of the portfolio.
5. A stock’s sensitivity to changes in the value of the market portfolio is known as beta. Beta, therefore, measures the marginal contribution of a stock to the risk of the market portfolio.