Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM)
During the 60's, a trio of young graduate students at the University of Chicago (Harry Markowitz, Merton Miller and William Sharpe) wrote their PhD dissertations on the subject of the stock market. From their work came what is known today as Modern Portfolio Theory...and won for them Nobel Laureates in Economics.
Willliam Sharpe shared this award for his pioneering contribution to asset pricing theory. His model sought to explain how risky assets would be priced in equilibrium. Employing a number of simplifying assumptions, the Capital Asset Pricing Model he developed proposed that a stock's expected return was a function of its volatility relative to the volatility of the universe of risky assets, and that the most efficient portfolio was the entire universe of risky assets. The CAPM provides the intellectual foundation for the total-market index fund.
Equity risk is a combination of systematic and unsystematic risk:
- Systematic risk includes macroeconomic conditions affecting all companies in the stock market. Systematic risk cannot be diversified away.
- Unsystematic risk includes company and industry developments specific to individual securities. The effect of these can be reduced through sufficient diversification.
Investors should not expect markets to reward them for taking on risks that can be diversified away. They should expect compensation only for bearing systematic risk.