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Capital Market Theory is the theory developed in the 1960s and made popular by William Sharpe. It piggybacked on Modern Portfolio Theory but added a risk-free asset to portfolio mix. This allowed investors to build portfolios with two components: the risk-free asset, like Treasury Bills, and a Market portfolio which maximizes the return-over-risk ratio of all risky assets. This changed portfolio choice from the efficient frontier to the straight line from the risk-free rate to the Market portfolio, and the concept of multi-asset-class allocation was born.
For context, the slope of the resulting Capital Market Line can be used to find the return-to-risk relationship of any portfolio, given someone took the time to properly forecast rate of return and risk expectations. In the real world, large investment firms are more inclined to go through this process because they understand portfolio theory better than most individual investors.
In most cases risk is measured by standard deviation.
Doc: Who else was working independently on
the Capital Market Theory?
Mia: I know! Jack Treynor, John Lintner and Jan Mossin.
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9.6. It is the product of the allocation of 60% times risk of 16%.
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