The investor 's objective is to maximize the portfolio 's expected return, subject to an acceptable level of risk (or minimize risk, subject to an acceptable expected return). The assumption of a single time period, coupled with assumptions about the investor 's attitude toward risk, allows risk to be measured by the variance (or standard deviation) of the portfolio 's return. Thus, as indicated by the arrow in Figure 1, the investor is trying to go as far northwest as possible. As securities are added to a portfolio, the expected return and standard deviation change in very specific ways, based on the way in which the added securities co-vary with the other securities in the portfolio. An investor who can live with a lot of risk might choose portfolio A, while a more risk-averse investor would be more likely to choose portfolio B. One of the major insights of the Markowitz model is that it is a security 's expected return, coupled with how it co-varies with other securities, that determines how it is added to investor portfolios.

Capital Asset Pricing Model Building on the Markowitz framework, Sharpe (1964), Lintner (1965) and Mossin (1966) independently developed what has come to be known as the Capital Asset Pricing Model (CAPM). Investors choose portfolios along this line (the capital market line), which shows combinations of the risk-free asset and the risky portfolio M. In order for markets to be in equilibrium (quantity supplied = quantity demanded), the portfolio…