MPT proposes that all investments are reducible to two elements— riskand return—and assumes that investors are risk-averse in the sense that they will sacrifice returns to avoid riskand demand greater returns to assume risk. MPT says that such investors will best address their risk aversion by investing in a portfolio of investments in which they receive the greatest expected return for any given level of risk.
The expected return on an investment is simply the weighted average of all possible returns on it, and the riskof an investment is the dispersion of possible returns on that investment around the expected return. Under MPT, expected return on a portfolio of investments is simply the weighted sum of the expected returns on the individual investments; the risk, however, of a portfolio of invest ments is not necessarily the weighted sum of the risks (or dispersion in the returns) of the individual investments.
The central insight of MPT is thus that since variations in returns on individual investments may reduce the dispersion of returns on a portfolio of investments, portfolio riskis primarily a function of the degree of variance of individual investments compared to the portfolio as a whole. This means that portfolio riskis minimized through portfolio diversification.
MPT’s understanding of riskhas another important implication. With respect to any stock, two elements of risk can be distinguished: systematic riskand unsystematic risk. Systematic risk (also sometimes called market risk or undiversifiable risk) arises from the tendency of a stockto vary as the market in which it is traded varies.
Unsystematic risk (also sometimes called unique risk, residual risk, specific risk, or diversifiable risk) arises from the peculiarities of the particular stockbeing investigated.
Because under MPT’s diversification directive unsystematic risks can be diversified away to zero, market returns on a stock in a competitive market will not include any compensation for such risk.
Thus, market returns will be a function solely of the systematic risk, or the extent to which a particular stockvaries as the market of which it is a part varies. Measuring such riskand return is the main goal of capital asset pricing models.
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