Chapter 15

Through the Looking Glass of Modern Portfolio Theory

In This Chapter

arrow Getting portfolio basics under your belt

arrow Understanding the hypothesis of an efficient market

arrow Grasping the relationship between risk and returns

arrow Finding the best balance

In his book Through the Looking Glass, the sequel to Alice’s Adventures in Wonderland, Lewis Carroll describes a girl who walks through a mirror into a world of wonderful yet threatening nonsense. That pretty much sums up modern portfolio theory: The mathematical modeling of investing strategies is wonderful in its ability to make sense out of chaos, yet threatening in its current form because it attempts to utilize preposterous ideas and methods that are dangerous for the novice corporate financial analyst or investor. Nevertheless, this threatening nonsense holds lessons to be learned; although the assumptions we use in modern portfolio theory are incorrect or impossible to use in a functional way, they give us an understanding of the way things work in theory, which, in turn, gives us a foundation upon which to develop our understanding ...

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