The Relative Value Theory
I propose the following theory: rational investors allocate capital to maximize the probability-weighted geometric mean of payoffs. I present the theory’s rationale and investigate its implications. I find that diversification increases cumulative returns and asset values are relative. The theory does not make assumptions about investors’ risk preferences and explains the “risk premium” without using the utility function concept. In a world of rational, risk indifferent investors the market tends to a stable equilibrium characterized by all investors holding the market. I calculate equilibrium prices for a simple model. The theory uses a unique discount rate (to account for time value of money) and ignores the required rate of return concept. The theory addresses some of the CAPM’s inconsistencies. I conclude the theory is coherent and useful in explaining observable finance phenomena.
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- William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, 09.
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