Question

Briefly explain the difference in assumptions underlying portfolio theory and the capital asset pricing model (CAPM)

Answer 1

The following considerations explain the difference between portfolio theory and the capital asset pricing model (CAPM).

• Total risk, as measured by standard deviation, is the core of portfolio theory. Only the beta component is used in CAPM to deal with systematic or market risk.
• A portfolio's risk is calculated by adding up the risk of all the assets in the portfolio. Individual securities/assets that would be added to a portfolio's risk are measured using CAPM.
• Portfolio theory assesses performance in terms of per unit of total risk in evaluating portfolio performance. The CAPM formula calculates the returns per unit of systematic risk.