Page 204 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 7: Efficient Market Theory

with other assets’ returns. The mean and the standard deviation can be used to plot the Notes
relative risk and return of any selection of securities. Consider six asset classes:

Figure 7.1: Risk vs Return

This figure was constructed using historical risk and return data on Small Stocks, S&P
stocks, corporate and government bonds, and an international stock index called MSCI, or
Morgan Stanley Capital International World Portfolio. The figure shows the difficulty an
investor faces about which asset to choose. The axes plot annual standard deviation of
total returns, and average annual returns over the period 1970 through 3/1995. Notice that
small stocks provide the highest return, but with the highest risk. In which asset class
would you choose to invest your money? Is there any single asset class that dominates the
rest? Notice that an investor who prefers a low risk strategy would choose T-Bills, while
an investor who does not care about risk would choose small stocks. There is no one
security that is best for all investors.

Markowitz and the First Efficient Frontier
The first efficient frontier was created by Harry Markowitz, using a handful of stocks from
the New York Stock Exchange. Here it is, reproduced from his book Portfolio Selection
Cowles Monograph 16, Yale University Press, 1959. It has a line going to the origin,
because Markowitz was interested in the effects of combining risky assets with a riskless
asset: cash.
Figure 7.2: Efficient Frontier

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