“Critically discuss whether the CAPM makes portfolio theory redundant.”

Introduction

This assignment will explore whether CAPM makes portfolio theory redundant. The following areas will be discussed; Stages involved, functions and roles, important components, formula of cap-M, positive and negative aspects of Cap-M, all while drawing to the conclusion to whether Cap-M makes portfolio theory redundant. (ref:2)

Definition

CAPM is defined as Capital asset pricing model. It is an economic theory and is used in Finance to determine a theoretically appropriate rate of return of an asset. It is a model that describes the relationship between risk and expected return. 2,5 CAPM can be used when pricing the risk of securities. It is the …show more content…

(Ref: 3,4,5).

The first assumption made is that investors are only concerned with expected returns and volatility. So as rational consumers, they should always maximise expected return for any given level of voliality. This follows on to the second assumption- all investors have homogeneous beliefs about the risk/ reward tradeoffs in the market. (Ref: 3,5,6)

Another assumption that CAPM makes is that all investors are broadly diversified across a range of investors, that they cannot influence price- this is certainly not the case for most economics markets nowadays. The model assumes that given a certain expected return, active and potential shareholders will prefer lower risk (lower variance) to higher risk and conversely given a certain level of risk will prefer higher returns to lower ones. (Ref: 3,4,5).

In conclusion While CAPM still leads the pack as one of the most widely studied and accepted pricing models; it is not without its critics. Its assumptions have been criticized from the start as being too unrealistic for investors in the real world. Time and time again empirical studies successfully dissect the model. However, CAPM makes the Portfolio theory redundant as all investors do not avoid risk. In fact nearly every investment carries an element of risk. (Ref: 3,4,5).

References

1. Portfolio Theory and the CAPM: Theory