Arnold Kling  


Correction to Modigliani-Mille... Debate With Wittman Continues...

Can the Capital Asset Pricing Model be explained without using math? I don't really think so, but I try in this essay.

Now, suppose another recipe-development project opportunity comes along. By shifting a portion of your portfolio into this new recipe-development project, you can gain the benefits of diversification. If diversification reduces your expected return, you can offset that by cutting back on your investment in risk-free securities and putting more into the "market portfolio" that combines the two recipe projects. Adding diversification to your portfolio lowers the price of risk, allowing you to have both higher returns and lower risk.

If the covariance between the two recipe projects is low, meaning that they are unlikely to both fail at once, then the diversification benefits are high, and you can shift a lot of funds out of the risk-free asset and into the market portfolio. If the covariance is high, then the diversification benefits are low, and the second recipe does not cause such a large portfolio shift.

The risk that remains in the portfolio with two assets is called market risk. There is always some market risk, because covariance is not zero, and diversification is imperfect.

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COMMENTS (2 to date)

How does one diversify one's human capital? That is an intriguing idea.

spencer writes:

I went all the way back and read your comments about can the Fed steer. The problem I have with your analysis is that you continue to look at the economy -financial markets as a closed system. But if you look at it as an open economy you get different results. Prior to 1990 the correlation between fed funds and bond yields exceeded 0.9. so when you talked about rates it really did not martter if you were looking at short or long rates. They moved in lock step and if one rose the other did too. But since 1990 the correlation between the long bond and fed funds has fallen sharply while the correlation between domestic bond yields and foreign bond yields has risen sharply. As the economy has become more dependent on foreign capital the ability of the fed to manage the economy has fallen significantly and the impact of foreign capital has risen sharply -- you get the same thing if you put both fed funds and foreign yields in a regression model -- the weight of fed funds falls and the weight of foreign rates rises.

So now when you are looking at a "market portfolio" you need to expand that portfolio to include foreign assets and the standard portfolio almost everyone uses that only includes domestic assets is no longer valid.

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