Investors attempt to optimize in a particular manner as proposed by Harry Markowitz’s Modern portfolio theory. And that manner is referred to by him as rationality. According to the theory, rational behaviour is warranted as investors are led to decide in uncertainty. Investors wanting to earn the maximum return is as rational as sun rising in the east. Since the return on a risky asset depends on values that various market and asset variables can take in future and the future is unknown, it becomes imperative that rational behavior of investor also considers risk of investing. A risky asset with higher expected volatility is bound to be under-preferred by the rational investor versus a risky asset with comparatively lesser expected volatility. The crux of efficient portfolio theory as per Markowitz, thus, becomes the efficient frontier, essentially a Pareto line optimizing in two dimensions – expected return and the variance of such return
(Markowitz H. M., 1990). Also, it can be noted that expected return is a desirable thing and variance of the return is an undesirable thing. (Markowitz H. , 1952)
Therefore, the process of portfolio building is, evidently, aiming to earn maximum possible return, while anchoring the risk parameter. Maximizing the anticipated return is a function of different variables estimated and used in the valuation process. Whereas, curbing the risk in the portfolio requires defining the risk in the first place. First, the asset class risk – that is hovering around the class of the asset as a whole; second, the security-specific risk – that’s the sensitivity of the security’s returns to changes in prices of the benchmark portfolio. The asset class risk can be brought down by diversifying across different classes of assets. Similarly, portfolio-specific risk can be reduced by different portfolios with directional movements that are divergent from each other.
The portfolio theory of Markowitz has well established that the security-specific risk can be brought down with ease by constructing a portfolio with an optimum proportion of a set of securities between whom the co-linearity is minimum. A mutual fund is supposed be a tool that can work in this direction, for an investor, who wishes to rely on the professional to take up the risk management task. Every mutual fund theoretically and practically is a diversified portfolio and supposed to be bringing down the volatility factor for the investor, as compared to a singular investment decision. And because, mutual funds take care of the security-specific risk, to a large extent, the risk that investors may have to focus would be the asset-class risk or the market risk.
It is well established that a rational investor would choose a combination of risk-free rate (defined as the rate in the absence of demand for any risk premium) and risk premium, through the seminal contributions of William Sharpe. Sharpe raised the question on the relationship between the risk and return of a portfolio and developed an asset pricing model that focused entirely on building a portfolio that minimized the difference between the marginal utility of investing in any security in a given portfolio. This was achieved by quantifying the assumed linear relationship between the expected returns on securities and their covariance with the market portfolio, viz., beta.
(Sharpe, 1990). The beta could be obtained by,