Introduction to Asset Pricing and the Modern Portfolio Theory

Asset pricing is about the determinants of stock returns and how to optimise the performance of stock portfolios, not about the valuation of stocks. Asset prices are the prices for which financial instruments, such as stocks and bonds, are bought and sold. Fundamentals, risks, and sentiment may be derived from these prices. The decisions of a large group of individual investors (including groups as asset management firms) create one single market price for an asset. There are two main approaches to the behaviour of individuals that make these investment decisions, which are

  • The rational approach
    Individuals are fully rational and therefore do not make any mistakes. Markets are efficient and prices are correct.
  • The behavioural approach
    Individuals are boundedly rational and sensitive to psychological biases. Therefore, there might be mispricing at the asset prices.