Abstract

This paper tests the relationship between average return and risk for New York Stock Exchange common stocks. The theoretical basis of the tests is the “two-parameter” portfolio model and models of market equilibrium derived from the two-parameter portfolio model. We cannot reject the hypothesis of these models that the pricing of common stocks reflects the attempts of risk-averse investors to hold portfolios that are “efficient” in terms of expected value and dispersion of return. Moreover, the observed “fair game” properties of the coefficients and residuals of the risk-return regressions are consistent with an “efficient capital market”–that is, a market where prices of securities fully reflect available information.

Scientific Portfolio AI- Generated Summary

This paper discusses the relationship between risk and return in the context of portfolio theory. The paper presents the Sharpe-Lintner asset pricing model, which is an extension of the one-period portfolio models of Markowitz and Tobin.

Fama argues that the appropriate measure of an investment asset’s risk is its covariance with the market portfolio, rather than its variance. He shows that the expected return on an investment asset is proportional to its covariance with the market portfolio, and that this relationship holds in equilibrium.

The paper also discusses the implications of this relationship for portfolio selection and asset pricing. Fama argues that investors should hold a well-diversified portfolio that includes all assets with positive expected returns, and that the expected return on an asset should be proportional to its covariance with the market portfolio.

Fama’s research has important implications for investors and financial analysts. It suggests that investors should focus on the covariance of an asset with the market portfolio, rather than its variance, when assessing its risk. It also suggests that investors should hold a well-diversified portfolio that includes all assets with positive expected returns, and that the expected return on an asset should be proportional to its covariance with the market portfolio.

Overall, Fama’s paper provides valuable insights into the appropriate measure of an investment asset’s risk and its relationship with its expected return in equilibrium. It highlights the importance of diversification and the need to consider the covariance of an asset with the market portfolio when assessing its risk. These insights have important implications for investors and financial analysts and can help them make better investment decisions.