are shocked around and then pushed back toward that equilibrium. The second reason we take an equilibrium approach is that we believe this provides the appropriate frame of reference from which we can identify and take advantage of deviations. While no financial theory can ever capture even a small fraction of the detail and complexities of real financial markets, equilibrium theory does provide guidance about general principles of investing. Financial theory has the most to say about markets that are behaving in a somewhat rational manner. If we start by assuming that markets are simply irrational, then we have little more to say. Perhaps we could find some patterns in the irrationality, but why should they persist? However, if we are willing, for example, to make an assumption that there are no arbitrage opportunities in markets, which is to assume that there are no ways for investors to make risk-free profits, then we can look for guidance to a huge amount of literature that has been written about what should or should not happen. If we go further and add the assumption that markets will, over time, move toward a rational equilibrium, then we can take advantage of another elaborate and beautiful financial theory that has been developed over the past 50 years. This theory not only makes predictions about how markets will behave, but also tells investors how to structure their portfolios, how to minimize risk while earning a market equilibrium expected return. For more active investors, the theory suggests how to take maximum advantage of deviations from equilibrium. Needless to say, not all of the predictions of the theory are valid, and in truth there is not one theory, but rather many variations on a theme, each with slightly different predictions. And while one could focus on the limitations of the theory, which are many, or one could focus on the many details of the different variations that arise from slight differences in assumptions, we prefer to focus on one of the simplest global versions of the theory and its insights into the practical business of building investment portfolios. Finally, let us consider the consequences of being wrong. We know that any financial theory fails to take into account nearly all of the complexity of actual financial markets and therefore fails to explain much of what drives security prices. So in a sense we know that the equilibrium approach is wrong. It is an oversimplification. The only possibly interesting questions are where is it wrong, and what are the implications? Nonetheless, suppose we go ahead and assume that this overly simple theory drives the returns on investments. One great benefit of the equilibrium approach to investing is that it is inherently conservative. As we will see, in the absence of any constraints or views about markets, it suggests that the investor should simply hold a portfolio proportional to the market capitalization weights. There may be some forgone opportunity, and there may be losses if the market goes down, but returns are guaranteed to be, in some fundamental sense, average. Holding the market portfolio minimizes transactions costs. As an investor there are many ways to do poorly, through either mistakes or bad luck. And there are many ways to pay unnecessary fees. The equilibrium approach avoids these pitfalls. Moreover, no matter how well one has done, unfortunately there are al-