Page 277 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes 3. Investment Implications: CAPM tells us that all investors will want to hold “capital-
weighted” portfolios of global wealth. In the 1960s when the CAPM was developed, this
solution looked a lot like a portfolio that was already familiar to many people: the S&P
500. The S&P 500 is a capital-weighted portfolio of most of the US’ largest stocks. At that
time, the US was the world’s largest market, and thus, it seemed to be a fair approximation
to the ‘cake.’ Amazingly, the answer was right under our noses – the tangency portfolio
must be something like the S&P 500 Not co-incidentally, widespread use of index funds
began about this time. Index funds are mutual funds and/or money managers who simply
match the performance of the S&P. Many institutions and individuals discovered the
virtues of indexing. Trading costs were minimal in this strategy: capital-weighted portfolios
automatically adjust to changes in value when stocks grow, so that investors need not
change their weights all the time – it is a “buy-and-hold” portfolio. There was also little
evidence at the time that active portfolio management beat the S&P index – so why not?
4. Is the CAPM true?: Any theory is only strictly valid if its assumptions are true. There are
a few nettlesome issues that call into question the validity of the CAPM:

(a) Is the world in equilibrium?
(b) Do you hold the value-weighted world wealth portfolio?
(c) Can you even come close?
(d) What about “human capital?”

While these problems may violate the letter of the law, perhaps the spirit of the CAPM is correct.
That is, the theory may be a good prescription for investment policy. It tells investors to choose
a very reasonable, diversified and low cost portfolio. It also moves them into global assets, i.e.
towards investments that are not too correlated with their personal human capital. In fact, even
if the CAPM is approximately correct, it will have a major impact upon how investors regard
individual securities. Why?

11.2 Portfolio Risk

Suppose you were a CAPM-style investor holding the world wealth portfolio, and someone
offered you another stock to invest in. What rate of return would you demand to hold this stock?
The answer before the CAPM might have depended upon the standard deviation of a stock’s
returns. After the CAPM, it is clear that you care about the effect of this stock on the TANGENCY
portfolio. The diagram shows that the introduction of asset A into the portfolio will move the
tangency portfolio from T(1) to T(2).
Figure 11.2

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