Essay on Introduction Of Modern Portfolio Theory

1414 Words Dec 6th, 2016 6 Pages
Modern Portfolio Theory (MPT) introduced by Harry Markowitz [1952], Jack Treynor [1962], William Sharpe [1964], John Lintner [1965], and Jan Mossin [1966] states, expectation of return must be accompanied by risk, the variation (volatility) around the expected return. Volatility is the uncertainties around expectations that investors may lose their investment due to unexpected fluctuation in the market price of securities. Moreover, a decision to hold a security should not be made solely on its expected return and variation around it, but rather a decision to hold any security depends on what other securities the investor wants to hold. MPT assumes that higher risk is compensated on average by higher returns. MPT established the Capital Asset Pricing Model (CAPM) which further provided the framework for examining risk and return relationship by introducing the concept of diversifiable and non-diversifiable risk. The volatility can be decomposed into diversifiable and non-diversifiable portions. The diversifiable portion is known as the unsystematic risk. It is the risk that is associated with an individual security or an investment. For example, if a side-effect of a drug currently on the market is discovered, an investor holding the drug maker may be severely impacted. However, an investor holding the same drug company in a diversified portfolio will not likely experience significant loss from that company specific event. The non-diversifiable portion of is…

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