Modern Portfolio Theory: Foundations, Analysis, and New Developments, + Website

Chapter 17

Portfolio Construction and Selection

If the capital asset pricing model (CAPM) is valid, then selecting an investor's optimal portfolio will consist of determining his or her utility function and choosing the appropriate mix of the risk-free asset and market portfolio. All securities would be priced so they plot exactly on the CAPM (also known as the security market line or SML), and there would be no overvalued or undervalued securities. In this situation, it can be said that current security prices fully reflect all information and that security markets are efficient. Note that in this situation, no investor is expected to earn abnormal returns, where abnormal return is defined as a return that is greater than normal for the amount of risk borne by the investor.

17.1 Efficient Markets

West (1975) provided a general interpretation of the notion of efficient markets. It is generally accepted that a major economic goal is to have allocationally efficient markets. That is, it is desirable to have capital channeled to where it can do the most good. This will occur when those economic units with the most promising investment opportunities get the necessary funds. In order to have allocationally efficient markets, it is necessary to have both internally and externally efficient markets. Internal (or operational) efficiency refers to the cost and speed of transacting. External (or pricing) efficiency refers to prices that adjust to new information quickly and in an unbiased ...