Lecture 14: Mutual Fund Theorem and Covariance Pricing Theorems

This lecture concerns the Capital Asset Pricing Model (CAPM). Even though
the ideas of diversication (i.e., "Each boat on a dierent ocean"), and risk
and return have been known for several centuries already, it wasnt until a few
decades ago that economists have formalized in a quantitative way the concept of
diversication (e.g., "Dont put all your eggs in one basket"). The diversication
theorem in CAPM becomes the mutual fund theorem, which has very practical
advice.
It says that if you are investing in the stock market, do not try to pick out
individual stocks. Instead, hold every stock in proportion to its value in the
whole economy. If you want to be more venturesome (if you like risk), dont
pick riskier stocks, but just simply leave less money in the bank (or the safe
asset). Thus, you need to divide all your money between the index and the
bank and hold all your money in stocks in the same proportion then everyone
else is holding them. In other words, holding the index is equivalent to holding
the market. In practical terms, you hold an index like the S&P 500, of all the
stocks, in proportion to how big they are. And if you are cautious, put some of
your money in the index and some of it in the bank. If instead you want to be
more venturesome, take some money out of the bank and put it into the stocks.
If you want to be even riskier than that, borrow the money to put the money into
the stock market (i.e., leverage). But you should, according to this theory, not
try to pick stocks. If you are interested in risk for instance, you shouldnt pick
high technology startup companies. Instead, you should pick the same mixture
of blue chip companies like General Electric and some startup companies that
everybody else is choosing. In common words, diversifying means holding a
little bit of everything in the same proportion as everyone else.
The covariance pricing theorem says that to adjust for risk the price of a
RJ
V ar(M; RJ ))
security, J you need NOT use the variance (e.g., J = E1+r
or the standard deviation of the security but assets J covariance with the
market. This is a surprising result. Thus, to penalize the price of a stock, which
should go lower if it gets riskier, you need to use a measure of risk that is not
dened by what its variance is, but by what its covariance is with the market
RJ
(i.e., J = E1+r
Cov(M; RJ )).. This lecture will develop these two ideas in
greater detail.
We will imagine that the asset world comprised of a number of states s =
1; :::; S each occuring with probability s . Obviously, the sum of probabilities
PS
has to equal 1 (i.e., s=1 s = 1). The economy consists of J assets denoted by
Aj where j = 1; :::; J, and the payo of asset Aj in period s is Ajs : Given these
probabilities and payos, we can compute the expectation and variance of each
asset:
E Aj =

S
X
s=1

j
s As

=A

(1)

V ar(Aj ) =

S
X

j
s (As

A )2

(2)

s=1

The covariance of any two assets Aj and Ak is going to be: Covs (Aj ,Ak ) =
PS
j
k
j
A )(Aks A ):
s=1 s (As

Assets and States of the World

The expectation, the variance and the covariance between any pairs can be
computed knowing the payos of the assets and their associated probabilities.
The capital asset pricing model is going to explain how the prices of all the
assets depend on their expectation, their variances and their covariances, under the assumption that people have quadratic utilities, or more generally, that
people only care about the mean or the expectation and variance of nal
consumption. We said previuosly that if you had quadratic utility for consumption in every state, you could summarize the various states of the world only by
the expectation and the variance of the nal portfolio. Remember that people
like expectation and dislike variance.
The theory of CAPM was developed in the 1950s by the Yale economist
Koopmans and one of his students, Harry Markowitz. Koopmans had the idea
of trying to examine risk by assuming people had quadratic utilities. He asked
his student to work on this theory, who managed to go quite a ways and receive
a Nobel prize for his work. However, Markowitz didnt quite nish the theory.
The nal crowning achievement was provided by the great Yale economist Tobin
who added the mutual fund theorem to the Markowitz setup, and subsequently
won the Nobel Prize for that. In fact, the New York Times said in its description

of what he won the Nobel Prize for, that, "James Tobin won the Nobel prize
for showing that you shouldnt put all your eggs in one basket."
Obviously, the theory is less trivial than that. The foundation of the theory
is that people dislike risk as measured by the standard deviation. Markowitz
introduced a rudimentary but rigorous model of uncertainty and risk aversion
into Finance by supposing that all investors would prefer a portfolio if its total
payos had higher expectation and lower variance.
To illustrate those preferences, Markowitz introduced the mean-standard
deviation diagram:

Markowitz Indierence Curves

Welfare improves as we move in the northwest direction, with higher expectation and less standard deviation.
Let X be the payo if an investor put all his wealth into the rst asset and
let Y be his payo if he put all his wealth into the second asset. Then if he put
a fraction t into X and fraction 1 t in Y; then:
V ar(tX + (1

t)Y )

= Cov(tX + (1 t)Y; tX + (1 t)Y ) =

Cov(tX; tX) + Cov(tX; (1 t)Y ) + Cov((1

t)Y; tX) + Cov((1

Assuming that X and Y are independent and because of linearity, we have

that:
V ar(tX + (1

t)Y ) = t2 V ar(X) + (1

t)2 V ar(Y )

(5)

If for example t = 1=2; then V ar(1=2X + 1=2Y ) = 1=4V ar(X) + 1=4V ar(Y ),
which shows that with two independent risky assets the portfolio has the same
3

t)Y; (1

(3)
t)Y
(4))

expectation but
p less variance. In fact, the standard deviation of your portfolio
is lower by 1= 2.
To use an analogy, if you have one die, and you pay 100 dollars for it, you
can get as a return 100 plus the number of dots showing. For instance, if you
roll a 1 the payo is 101 dollars, or if you roll a 6, the payo is 106 dollars.
If you held one dice only, you would get on average 103.5 dollars. Thus, you
could pay 100, get 1 die, and on average receive 103.5. Instead, you could put
50 dollars in the rst die, get half of that, 50 dollars in the second die, get half
of that. So on average, youre still getting 103.5, but the variance you get is
going to be half of what it was before.
Pictorially, if X and Y are independent, have the same expectation and risk
(i,e, X = Y ) and now you put half your money in each, you can cut the
variance in half, or you divide the standard deviation by the square root of 2.
Thus you have improved by moving to the left. You have less standard deviation
without constricting your expectation at all.

Diversication with two assets

After present value, diversication is the most important principle in nance.
A good investor is always looking for independent investment opportunities.
One of the chief selling points of many hedge funds is that their returns are
independent of the rest of the market.
Diversication Theorem Let 2Y > 0 and let X and Y be independent.
Then for some small t, the portfolio Z(t) = tX + (1 t)Y has lower variance
than Y , no matter how high 2X is.
Proof: Note that V ar(Z(t)) = t2 V ar(X) + (1 t)2 V ar(Y ): Hence:

d
V ar(Z(t)) = 2tV ar(X)
dt
Evaluated at t = 0;
d
V ar(Z(t)) =
dt
Then, for small t > 0

2(1

t)V ar(Y )

2V ar(Y ) < 0

V ar(Z(t)) < V ar(Z(0)) = V ar(Y )

(6)

(7)

(8)

Important as this principle is, it is often misunderstood. Diversication

allows the investor to obtain safer returns. But the principle does not say that
investors should try to avoid risky securities. Indeed, an independent asset
generating at least the same return as a portfolio is always worth adding to the
portfolio (at least in small quantities) no matter how risky it is. This can be
illustrated below:

Risk Reduction through

diversication
The expectation of the portfolio of Y and X goes up relative to just investing
in Y , because it is going to be the average of X and Y . In addition, the variance
is not going up, since they are independent. Thus, even though X has a way
higher variance than Y , mixing a little between the two lowers the variance of
the porfolio.
The diversication argument holds even when X and Y are not independent
and have dierent risks. For instance suppose that Cov(X; Y ) = XY > 0,

the correlation coe cient is XY < 1 and

portfolio Z(t) = tX + (1 t)Y becomes:
V ar(Z(t) = t2

2
X

t)2

+ (1

2
Y

<

X:

Now, the variance of the

+ 2t(1

t)

XY

(9)

Now:
d
V ar(Z(t)) = 2t
dt
Evaluated at t = 0;

2
X

2(1

d
V ar(Z(t)) = 2
dt
since the inequality is equivalent to:
XY
X

<

t)

2
Y

2
Y

+2

+ 2 [1

XY

<0

2t]

XY

(10)

(11)

(12)

Y
it is veried since X
< 1:Thus, even though the slope at t = 0 is steeper
than before, we still nd that a combination of X and Y even when positively
correlated reduces the variance of the portfolio. Graphically we can show this
by:

Risk Reduction with Correlated

Assets
If they are perfectly correlated, (say Y is just 80% of X), moving back
between them is not really changing anything - the portfolio has both more
expectation and more standard deviation. If that were the case, you would just

move on that straight line that connects the two points and diversication has
no benets. If they are independent, you are going to move along that the most
bowed out line. If the two assets are positively but not perfectly correlated, the
the porfolio risk and return move along the line in the middle and you will be
always above the straight line.

0.1

The Mutual Fund Theorem

We know from previuos lecture that if there had been hundreds of stocks and
millions of states of nature, and each person had a dierent utility, dierent
risk aversion, but all quadratic, and you calculated the competitive equilibrium,
assuming there were Arrow securities, it would end up that every consumer
held the same mix of all these stocks, plus some positive or negative amounts
of the bond. Therefore, the best thing everybody could do was hold the same
proportion of stocks and bonds, and maybe more or less of the riskless asset,
maybe even a negative amount of the riskless asset.
Suppose now we have three stocks, X, Y and Z whose prices are in equilibrium.

Risk reduction portfolios

For each we know the expectation and standard deviation per dollar of the
stock. Maybe the person has exactly I dollars that he is going to spend on
these stocks. He could put all his money into X, or all his money into Y , or
all his money into Z. But maybe he wants to divide part of his money in X,
part in Z and part in Y . The bowed out curves show the possible combinations
between any two stocks. Combining X and Y , or Y and Z, or X and Z gives

diversication benets. But one can do even better by combining the combination and obtaining the payo Q = 12 ( 23 X + 31 Z) + 13 ( 23 Y + 13 Z). By taking such
a combination over and over one gets all feasible portfolios. The feasible shape
must be:

Feasible Combination
The Markowitz investor will choose the feasible portfolio whose payos maximize his utility.

Markowitz Portfolio
Of course, dierent investors (with dierent risk aversion) will typically
choose dierent portfolios. If somebody is not very worried about the standard deviation and cares a lot about expectation, they are going to have a
atter indierence curve. So instead of looking like that, it will be a atter
thing. And if its atter, it means he cares about expectation and not standard
deviation, because a little bit of expectation can compensate him for a lot more
standard deviation. He is then going to choose further up a point with a higher
expectation and higher standard deviation.
Tobins contribution has been to introduce a riskless asset. Lets suppose we
have a bond that pays something for sure, and we are going to ignore ination.
For instance, a US Treasury bond is going to pay a certain amount of money
for sure. So it has a sure expectation, but no standard deviation. Suppose that
Y now denotes the riskless bond. A combination of (1 t)Y and a risky asset
tX yields a return which is simply the weighted average of the two:
E (tX + (1

t)Y ) = tX + (1

t)Y

(13)

Because the riskless Y has variance of zero then:

t)Y = t2

V ar(tX + (1

2
X

(14)

and then the standard deviation of the portfolio will simply be t X : In other
words, the standard deviation of the mixture of Y and X lies right on a straight
line:

The line connecting X and Y can be extended to denote leveraging (borrowing money) to invest in the risky asset X. Putting together all the information
from above, which combination of stocks and bonds would you hold? The answer is that we just have to look for a line through the riskless point that is
tangent to feasible line, and now an investor should choose a point anywhere
along that line, independent of what the investors mean-variance utilities are.
In other words, no matter how risk averse you are or how risk loving you are,
you should choose somewhere along this line:

10

E cient allocations
All the best possible combinations of the riskless bond and the risky assets
lie on the line that is tangent to the e cient frontier. If I am risk averse, my
portfolio combination will be to the left of the tangent point. But if I love
risk, I will borrow money and invest in the market portfolio to the right of the
tangency point.
In short, this is the mutual fund theorem. It says that everybody should
invest in the same index of stocks and put more or less money in the bank. So
every single person ought to be doing the same thing. This is the mutual fund
that everybody should hold. Whatever combination of stocks that got me to
this point is the mutual fund that everybody should hold, and combine that
with putting money in the bank.
Now we are going to prove the theorem algebraically. Suppose that we have
j
J risky assets Aj where the returns on each asset are Rj = Aj : There is also
a riskless asset (A0 ) with return R0 . The investor has I dollars to invest and
he wants to choose how much money he is going to put in each asset, ! 1 ; :::! J .
If he does that, hes going to have a portfolio, denoted by R! , with a certain
expectation and a certain variance. Remember that the investor cares about
the expectation and hates variance.
We are going to use a special case, described rst by Tobin and which is easy
to solve. Suppose further that all assets payos are independent. Then we can
rewrite the problem as:

11

2 2
0 !0

max R0 ! 0 + R1 ! 1 + ::: + RJ ! J
= I

2 2
1 !1

+ ::: +

s:t:! 0 + ! 1 + ::: + ! J
PS
where Rj = s=1 s Rsj is the expected payo of $1 in asset j, and 2j =
P
Rj )2 is the variance of the payo from $1 invested in asset j.
s2S s (Rsj
The coe cient is the coe cient of risk aversion. Every investor will have a
dierent :
We can simplify the problem by substituting for ! 0 and noting that 20 = 0:
This gives the unconstrained problem:
max R0 I + (R1

R0 )! 1 + (R2

R0 )! 2 + ::: + (RJ

R0 )! J

2 2
1 ! 1 + ::: +

2 2
J !J ]

(16)
Clearly, at the optimum for each j, by lookingat the marginal utility of a
dollar spent in asset j, we know that the partial derivative with respect to ! j
must be zero, which gives:
(Rj

R0 )

!j =

Rj
2

2
j !j

=0

(17)

which implies that:

R0

(18)

2
j

The remarkable property of the solution to the Markowitz problem when

there is a riskless asset is that the proportion of risky securities held does not
depend on the risk aversion of the investor.
!i
(Ri
=
!j
(Rj

R0 )=
R0 )=

2
i
2
j

(19)

Unlike the Markowitz case, in the Tobin case everybody chooses the same
combination of risky assets and safe asset. So it may be that dierent people put dierent combinations of safe and risky, but everybodys proportion of
risky assets is proportional to everybody elses. That is what we just proved
algebraically.
In fact the same conclusion holds for any dierentiable utility function
U (E; V ) that depends only on the mean (positively) and on the variance (negatively) of the nal payos. We would get the problem:
max U R0 I + (R1

R0 )! 1 + (R2

R0 )! 2 + ::: + (RJ

which gives

12

R0 )! J ;

2 2
1 !1

+ ::: + 2J ! 2J
(20)

2 2
(15)
J!
J

@U
(Rj
@E

R0 ) +

@U
2
@V

2 2
j !j

(21)

) !j =
The term

@U
@E
@U
@V

Rj R0
2 2j

@U
@E
@U
@V

(22)

is common to all choices j, hence we get as before:

!i
(Ri
=
!j
(Rj

R0 )=
R0 )=

2
i
2
j

(23)

We can see this pictorially in the picture Tobin made famous:

Tobin diagram
The line tangent to the market frontier is called the Capital Market Line
(CML). Notice now that an investor with a small
will choose a higher expectation, higher standard deviation portfolio, but still choose along the line,
with the same mix of risky securities. In conclusion, the index that all investors
need to hold is the market portfolio (e.g., S&P 500). The tangency point is
the optimal risky portfolio. Tobins discovery essentially led to the birth of the
mutual fund industry. In the Tobin diagram the slope of the CML is the Sharpe
ratio (SR) (should have been called the Tobin ratio though):
SR =

E(Rj )

R0

An investor managing all his money should maximize his Sharpe ratio.
13

(24)

As an application to Markowitz formula and Tobins special case, we can

provide very specic nancial advice. Suppose weve got two stocks, i and j,
with the same expected return, but one has standard deviation 3 times higher
than the other. How should you allocate your money between the two stocks?
According to the optimal ratio above, one should put 90% in the safer stock
and 10% in the riskier stock.
The second advice is to also buy global stocks (i.e., world index) and seek
out independent risks.
Going back to the dice example, remember that the average payo of rolling
the dice is 103.5. Let us now introduce a riskless asset that pays 3%. With one
die we can nd the variance as 61 (1% 3:5%)2 + ::: 16 (6% 3:5%)2 = 0:029% the
Sharpe ratio is:
0:035 0:03
0:005
=
(25)
0:017
0:017
or about 0.3. In the stock market today you can usually nd stock with
Sharpe ratios in the range 0.3 to 0.7. In fact 0.3 is close to the Sharpe ratio
of the market (i.e., (9% 4%)=16% = 0:3): Notice that the investor is losing
money 50% of the time. But lets say the investor diversies into a second dice
investment. Now to get the worst case scenario (i.e., $101) is not 1/6 but 1/36.
By combining the dice and diversifying, a shrewd investor could nd a risky
portfolio with expectation
1.035 and variance 0.00029/2, and hence a standard
p
deviation of 0:017= 2 = 0:012: This gives a Sharpe ratio:
0:035 0:03
= 0:4
(26)
0:012
Therefore, the addition of an independent risk automatically lifts the Sharpe
ratio.
Now, what can we say about the pricing of individual stocks? We know from
basic Economics that the price of a good is given by the marginal utility. We
have shown that everybody is holding the market, maybe with some riskless
asset. So suppose I hold the market portfolio and I buy a t amount of stock X:
tX + M: By holding tX, expected return increases by tE(X). Now, what would
happen to the variance of the portfolio? The variance will be:
V ar(tX + M ) = t2

2
X

2
M

+ 2t

XM

(27)

Now if we dierentiate with respect to t to assess how the variance of the

portfolio changes with the addition of stock X:
d
V ar(tX + M ) = 2t 2X + 2 XM
(28)
dt
When t 0; then we see that the variance of the portfolio increases by twice
the amount of stocks X covariance with the market. This is the crucial idea,
that the marginal contribution of every stock depends on its expectation and
its covariance, not its variance. Thus, when one adds $1 worth of X the utility

14

changes by M UX E(X) M UV Cov(X; M ) (i.e., goes up by E(X) but decreases

by the amount of covariance with the market). The punch line is then that
everybody has a linear tradeo between expectation and covariance.
We can show this linear trade-o using the Security Market Line (SML):

Security Market Line

The SML shows that every stock should be priced along that line and an
investor requires a higher expected return in order to hold a stock with a higher
covariance with the market. The intercept of the SML is equal to the risk-free
interest rate and the slope of the security market line is equal to the market risk
premium and reects the risk-return trade-o at a given time:
SM L : E(X) = R0 + [E(M )

R0 ]

(29)

The coe cient is in turn given by the ratio XM = 2M :

As another application lets nish with a puzzle. If we have two companies,
General Electric and an anti-AIDS company where the latter pays a fortune if
successful or go bankrupt otherwise. Which one will sell for a higher price? The
answer is the anti-AIDS company since its payos are not correlated with the
market. General Electric is the one with the higher risk, because it is correlated
with the market. The price of General Electric is going to be much less, because
it is going to be punished for having a correlation with the market. Therefore
the return on General Electric is going to be much higher, because with the
same expected payo and a lower price, your return is going to be higher in
General Electric.

15

0.1.1

History of CAPM

Sharpe in 1967 found that up to that point the implications of the CAPM and
of the covariance pricing theorem were amazingly veried by the data. All
expected returns looked incredibly close to a straight line. Now, as it happens,
as the theory has been tested over and over again every year since 1967 it has
performed more and more poorly. It is pretty shocking how up until 67 or the
early 70s that it seemed to work out perfectly and now it doesnt work very
well.

16