Modern Portfolio and Capital-Asset Pricing Theory

Modern Portfolio and Capital-Asset Pricing Theory

… Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribber of a few years back. (J.M. Keynes, General Theory of Employment, Interest and Money).

I have attempted to explain the theories used by professionals – simplified as the firm-foundation and castle-in-the-air theories – to predict the valuation of stocks. As we have seen, many academics have earned their reputations by attacking these theories. While not denying that these theories tell us a good deal about how stocks are valued, the academics maintain that they cannont be relied upon to yield extraordinary profits.

As graduate schools continued to grind out bright young economists and statisticians, the attacking academics became so numerous that it seemed obvious – even to them – that a new strategy was needed. Ergo, the academics community busily went about erecting its own theories of stock-market valuation. That’s what this part is all about: the academic playground called “the new investment technology.” Some people prefer to name it “capital-asset pricing theory,” or its related cousin “arbitrage pricing theory.” None of these titles conveys the heart of the matter, which is that when all is said and done, risk is the only variable worth a damn in the market.

Modern Portfolio. Photo by ElenaB.

Academic research, remember, has taken a random walk. The stock market is such an efficient creature that nothing and no one can predict its future in a superior manner. And, because of the actions of the pros, the prices of individual stocks quickly reflet all the information that is available. Thus, the odds of selecting superior stocks or anticipating the general direction of the markets are even. Your guess is as good as that of the ape, your stockbroker, or even mine.

Hmmmm. “I smell a rat,” as Samuel Butler wrote long ago. Money is being made on the market: some stocks do outperform others. Common sense attests that some people can and do beat the market. It’s not all chance. The academics agree: but the method of beating the market, they say, is not to exercise superior clairvoyance but rather to assume greater risk. Risk has its rewards. Risk, and risk alone, determines the degree to which returns will be above or below average, and thus decides the valuation of any stock relative to the market.

We’ll deal with the new investment technology and its somewhat tarnished star performer, beta. Being an academic, I hold to the biased viewpoint that this material is important and that every intelligent investor should be acquainted with the theories and models it includes. They explain how to reduce risk through diversification and present some of the ways to measure it. Even the investment professionals have latched on to much of the new investment technology. So, sit down in a straight-backed chair, prop your eyelids open, and read on. There is a lot to do and, as was the case before, necessarily the discussion must be a bit more formal than before (that mens it could put you to sleep). The wide-awake reader will be rewarded, however, with an understanding of a good deal of modern financial theory and of what lies behind some of the specific prescriptions for the investment strategy.

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.