Continuous compounding, volatility and the equity premium

Document description

This paper reviews some of the fundamental ideas of modern portfolio theory and the supporting empirical evidence that is relevant to actuarial modelling of equity markets or equities as an asset class. There is a chasm between those who believe that modern portfolio theory is absurd and those who believe it to be so logical as to be almost self-evident. This paper identifies ambiguity in the meaning of the term 'mean rate of return' as a partial cause of much of the controversy between advocates and critics of modern portfolio theory and share market efficiency. Depending on the appropriate meaning of 'mean rate of return', equity markets may not be mean-variance efficient which weakens the argument that stock market volatility is responsible for the superior long term performance of shares over less volatile asset classes.