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Efficient Market Portfolio
Modern portfolio theory is founded on the fundamental assumption that investors have rational investment decisions, where they expect higher returns for an increased level of risk. The CAPM and mean-variance analysis, which forms component of the modern portfolio theory, assumes that investors try to have a more efficient investment selection, where they seek highest expected yield for a certain level of variance (risk) or having the lowest variance for a certain level of the expected yield (Damodaran, 2008). However, the consideration of an asset’s yields as random variable that is elliptically distributed or more specifically as a function that is normally distributed, has been beleaguered by technical challenges, emanating from the original optimization problem’s instability, in respect of the data that is available. The recent research indicates disappearance of this kind of instabilities when the penalty term or regularizing constraint is integrated with the procedure of optimization.
Review of Efficient Market Portfolio
Markowitz Portfolio Theory, holds that an investor with a portfolio with optimal return (highest returns level) for a given risk level, cannot diversify further in order to increase the expected return without first taking higher amount of risk (Elton, 2010). On the same note, the investor cannot lower the risk exposure level without decreasing the level of expected returns proportionately (this is illustrated in the figure 1.0 below). In this regard, the efficient market portfolio means a given set of assets (investment vehicles), that will provide greatest level of the expected yields, for a particular level of undertaken risk (variance), or equivalently, providing the lowest level of risk for a given amount of the expected yield.
Figure 1.0: the graph of return versus risk as theorized by the Markowitz Portfolio Theory (Mayo, 2013).
Under the CAPM, an optimal (efficient) portfolio is considered to have both market portfolio and a risk-free investment. In a graphical representation, the capital market line depicts the highest returns level, which can be obtained given a certain level of risk, by combining both the risk-free and efficient portfolio. The tangency of the individual assets risk-return and the capital market line represents the efficient portfolio as illustrated in the figure 2.0 below.
Figure 2.0: the efficient portfolio as a tangency of the efficient frontier and capital market line (Michaud & Michaud, 2008).
The figure indicates the efficient frontier, which is the opportunity, set which provides the highest level of the expected returns, for a given risk level. As such, the efficient portfolio should have a zero alpha, meaning that the expected return per given level of risk and the required return is equals. This means that an efficient portfolio is unusually on the security market line. In order to improve the portfolio performance, the investor should thus sell the stocks that have negative alpha while buying the ones with positive alpha (Markowitz H., n.d) efficient portfolio is represented by the market portfolio, which has risk premium that commensurate with the security beta.
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