Capital market line

It is a simple matter to determine the relationship between risk and return for efficient portfolio.I draw 2 figures in this article. The figure first portrays graphically. Point M represents the market portfolio and point T the riskless rate of interest. Preferred investment strategies plot along line TMZ, representing alternative combination of risk and return obtainable by combining the market portfolio with borrowing or lending. This is known as the capital market line(CML).All investment strategies other than those employing the market portfolio and borrowing or lending the below the capital market line in an efficient market although some may plot very close to it.
The slope of the capital market line can be regarded as the reward per unit of risk borne. As the figure shows, this equal the difference between the expected return on the market portfolio and that of the riskless security_{Em-T} divided by the difference in their risks _{\sigma m-0} .
Equilibrium in the capital market can be characterised by the key numbers. The first is the reward for waiting or riskless interest rate, shown by the vertical intercept of the capital market line(point T in the above figure), The second is the reward per unit of risk borne, shown by the slope of the line. In essence, the capital market line provides a place where time and risk can be traded, and their prices determined by the forces of demand and supply. The internal rate can be thought of as the price of time, and the slope of the capital market line as the price of the risk.
The selection of a portfolio intended to act as a surrogate for the market portfolio can be considered a passive strategy, for it requires no security analysis. In a completely efficient market it may constitute the most reasonable approach to investment. In the real world one hopes to “beat”such a strategy.But the odds are not favorable,By investing in proportion to value outstanding an investor can be assured of performance equal to that of the average in the market. If one adviser or investor is to consistency outperform this average without taking on disproportionate amounts of risks, other must consistently underperform it. Investor of this latter variety may exist ,but they are not likely to be masochists or completely oblivious to their situation.

Manager employing passive strategies can provide a number of valuable services. risk control, diversification at low cost, convenient ways to add or withdraw funds etc. But to try to “beat the market”.Second figure portrays this.The analyst’s own opinions are shown here,not the consensus of professional analyst opinion. Realistically, even superior analysts must assume that combinations of the market portfolio and borrowing or lending dominate most alternative strategies.
Active investment management can have its benefits. But it brings costs as well. In the real world, trading costs money and may impact price adversely. Moreover, even a superior analyst cannot hope to identify a large number of seriously mispriced securities. Taxes do matter in the real world, and different investors are affected differently by them. These factors make in the real world, and different investors are affected differently by them.these factors make investment management more complicated than the CAPM would suggest.Accepting the inability of most managers to consistently “beat the market”,one still must accept the need for potentially rather complicated procedures designed to “tailor”an investment strategy to fit the circumstances of particular individual or institution.

 

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