Question

Suppose we live in a world where CAPM holds true. What is the optimal strategy for an investor who wants to builda portfolio that is riskier than the market?

Answer 1

Here we are assuming that we live in a world where CAPM holds true, in CAPM model the risk is measured in terms of beta. Beta is a measure of sensitivity of the risk and is a measure of relative risk. It measures risk in comparison to the market and the beta of market is taken to be 1. Now here you want to build a portfolio of stocks that is riskier than the market so you would consider adding stocks in your portfolio where the beta of the stock is greater than 1. The beta actually shows the relative return movement, when you add portfolio of stocks which has beta greater than 1 so it would be considered riskier than the market portfolio because the return would be magnified both ways up side as well as downside. Let say you have selected a portfolio of stocks where the beta of your portfolio is 1.7 which is greater than 1 so it is riskier. Now let’s assume that the expected return during a period from the market was 10%. The beta of your portfolio is 1.7, so the expected return from your portfolio should be 10% * 1.7 = 17%. Now let’s assume during the same period the expected return was -10% so your portfolio will lose value by -17%. Here capital allocation line would not work because you want to build a riskier portfolio than the market so you would have to select asset which have higher beta than 1.