The theory of portfolio selection developed in the previous chapter together with asset pricing theory described in this and the next two chapters provides the foundations for portfolio management. The goal of portfolio selection is to construct portfolios that maximize expected returns consistent with individually acceptable levels of risk. Portfolio selection theory, popularly referred to as mean-variance portfolio theory, prescribes a standard or norm of behavior that investors should pursue in constructing a portfolio. The theory does not necessarily intend to describe actual investor behavior. In contrast, asset pricing theory goes on to formalize the relationship that should exist between asset returns and risk if investors behave in a hypothesized manner. Thus, asset pricing theory is a positive theory. Based on this hypothesized investor behavior, asset pricing theory derives a model (called the asset pricing model) that specifies expected return, a key input in constructing portfolios based on mean-variance portfolio analysis.

In this chapter and the two that follow, major theories about a security's expected return based on asset pricing models are described. It is important to understand that portfolio selection theory is independent of any theories about asset pricing: The validity of prescriptive portfolio selection theory does not rest on the validity of descriptive asset pricing theory.

Together, portfolio selection theory and asset ...

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