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Portfolio Theory and CAPM in Decision Making

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1. Why do financial mangers have difficulty applying CAPM in decision making? What benefits does CAPM provide them?

2. Explain why assets must be evaluated in a portfolio context

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Why do financial mangers have difficulty applying CAPM in decision making?

The model [1] does not appear to adequately explain the variation in stock returns. Empirical studies show that low beta stocks may offer higher returns than the model would predict. Some data to this effect was presented as early as a 1969 conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is itself rational (which saves the efficient markets hypothesis but makes CAPM wrong), or it is irrational (which saves CAPM, but makes EMH wrong - indeed, this possibility makes volatility arbitrage a strategy for reliably beating the market).

The model assumes that investors demand higher returns in exchange for higher risk. It does not allow for investors who will accept lower returns for higher risk. Casino gamblers clearly pay for risk, and it is possible that ...

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