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In 1954 Harry Markowitz gave us the efficient frontier and the mean-variance criterion and showed that risk-averse investors applying this criterion should all invest in

In 1954 Harry Markowitz gave us the efficient frontier and the mean-variance criterion and showed that risk-averse investors applying this criterion should all invest in a portfolio on the efficient frontier. In 1958 James Tobin gave us the separation theorem separating the investment decision from the financing decision and then in 1963 Sharpe, Lintner and Mossin, independently, gave us the CAPM, how all investors should behave if they did what Markowitz said.

1) Explain how the Capital Allocation Line allows us to separate the investment decision from the financing decision and the conditions under which the Capital Allocation Line can become the Capital Market Line.

2) In the real-world investors do not hold the entire market as CAPM says they should. Give five brief reasons for this.

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