Standard Finance Theory

Standard finance theory, also known as modern portfolio theory, provides a framework for understanding how rational investors should make decisions regarding investment and risk. It’s built upon several core principles and assumptions, primarily focusing on maximizing expected return for a given level of risk or minimizing risk for a desired level of return. The efficient market hypothesis is central, asserting that asset prices fully reflect all available information, making it impossible to consistently achieve above-average returns without taking on additional risk.

A cornerstone of the theory is the concept of diversification. Investors are encouraged to build diversified portfolios to reduce unsystematic risk (also known as diversifiable risk), which is specific to individual companies or assets. By combining assets with different correlations, the overall portfolio’s volatility can be reduced without sacrificing expected return. This is quantified through portfolio optimization, often using the mean-variance framework. This framework uses historical data to estimate the expected return and volatility (standard deviation) of different assets, and then mathematically constructs the portfolio with the best risk-return tradeoff.

Capital Asset Pricing Model (CAPM) extends this concept by defining a specific relationship between risk and expected return for individual assets. According to CAPM, an asset’s expected return is equal to the risk-free rate of return plus a risk premium. This premium is determined by the asset’s beta, which measures its systematic risk (or non-diversifiable risk) relative to the market as a whole. In simpler terms, CAPM suggests that investors should be compensated for taking on systematic risk but not for unsystematic risk, as that can be diversified away. Thus, investors should only hold the market portfolio combined with risk-free assets.

Another crucial aspect is the time value of money. Standard finance theory acknowledges that money received today is worth more than the same amount received in the future, due to its potential earning capacity. This is reflected in concepts like present value and discounted cash flow analysis, which are used to evaluate investment opportunities by determining the present worth of future cash flows. These models utilize a discount rate (representing the required rate of return) to account for risk and opportunity cost.

The assumptions underlying standard finance theory, however, are often debated. The assumption of perfectly rational investors, the perfect efficiency of markets, and the use of historical data to predict future returns are all points of contention. Behavioral finance, a contrasting school of thought, challenges these assumptions by incorporating psychological factors into investment decision-making. Despite its limitations, standard finance theory provides a valuable foundation for understanding investment principles and constructing portfolios, even if modified by behavioral insights.