Portfolio Selection and the Capital Asset Pricing Model

6 Pages Posted: 5 Apr 2010 Last revised: 8 Sep 2017

See all articles by Marc L. Lipson

Marc L. Lipson

University of Virginia - Darden School of Business

Abstract

In the context of determining an optimal portfolio to recommend to two hypothetical investors, this structured analysis leads students through a series of steps examining return data for three stocks. The analysis first explores the effects of portfolio formation on returns and volatility. With the addition of a market index and a bond portfolio, students easily recognize how portfolios from these to investment vehicles may be optimal. The analysis then explores stock betas as a measure of risk and the statistical properties of those betas. At the conclusion, students will have a practical understanding of the capital asset pricing model.

Excerpt

UVA-F-1604

Rev. Aug. 29, 2017

PORTFOLIO SELECTIONAND THE CAPITAL ASSET PRICING MODEL

What portfolio would you recommend to a 28-year-old who has just been promoted to a management position, and what portfolio would you recommend to a 60-year-old who has just retired?

The perennial question in the world of personal finance seems to be “What should I buy?” A far better question would be “What portfolio should I hold?” The research exercise described in this note provides an opportunity to explore the reasoning behind this distinction. More importantly, it will become apparent that the answers to the portfolio question provide critical insights into how we measure risk and determine appropriate rates of return for a given level of risk. In particular, the analysis described here will develop familiarity with the capital asset pricing model (CAPM), a model of appropriate returns based on the relation between the returns on an individual asset and the returns on a broad market portfolio.

The analysis described here is organized around the question stated at the top of this page. To focus our analysis, we will ignore issues related to the amount of wealth these individuals might have, the tax situation each may face, and specific expenditure plans they might have. Simply assume that both have relatively large amounts to invest, but not so large that they are indifferent to the returns they might earn. Both would, of course, prefer higher returns to lower returns. The newly promoted manager, however, would be able to accept a higher degree of risk than the retiree.

. . .

Keywords: portfolio, returns, volatility, CAPM, investments

Suggested Citation

Lipson, Marc Lars, Portfolio Selection and the Capital Asset Pricing Model. Darden Case No. UVA-F-1604. Available at SSRN: https://ssrn.com/abstract=1583755

Marc Lars Lipson (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4837 (Phone)
434-243-5021 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/lipson.htm

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