How? parameter estimation error in expected return and covariance.
Example, with a 2 asset portfolio, let's say you overestimates A1 return by e and underestimates A2 by 2. Your average error is=0, which is pretty good.
With modern portfolio theory, you would invest a lot more in A1 and less in A2 and thus maximizing your error...
Quick review on CAPM, efficient frontier, etc.
In a nutshell, modern portfolio theory with CAPM picks a portfolio of risky assets (efficient frontier) and risk-free asset and maximizes the expected return for any given level of risk (volatility) / minimizes the risk for any given level of expected return.
How to maximize expected return? by investing more in assets with higher expected return.
How to minimize risk? by diversifying among assets have low correlation.
example, if you invest in oil company and airline company, you can minimize your risk due to oil price fluctuation. While both companies expect to make money, if oil price increases, earning of the oil company is expected to increase and that of the airline company is expected decrease due to higher cost and vice versa.
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