There is a wonderful relationship between the risk of an investment and its expected return value. This relationship is known as CAPM or Capital Asset Pricing Model. An asset’s expected return is how much you will be projected to lose or gain from investing in that asset.
Basically, it’s a pricing model used to estimate the pricing of a risky security or investment and generate expected returns on those risky securities. Well, at least that is how it pertains to the investment world. It has other uses outside of calculating risky investments.
The Basics Of Capital Asset Pricing Model
The riskier the investment, the more effective the capital asset pricing model, will be when assessing how the security may perform over a given period of time. The basis for this model is that you stand to gain a higher yield from investments that carry higher risk. This is why the CAPM is calculated by using a market-risk premium as one of the variables.
RISK-FREE RATE + (BETA x MARKET RISK PREMIUM) = EXPECTED RETURN
The Expected Return in the basic CAPM formula is what you can expect to earn over the lifetime of the investment. It’s a fairly decent Discount Rate that investors can use to determine how valuable an investment may be.
The Risk-Free Rate is equivalent to the yield of a 10-year government bond or treasury bond. If you’re calculating this outside of the U.S., use that local government’s 10-year bond.
Beta is an indicator of the stock’s risk, emphasizing how volatile that stock may be. If the risk of a stock is greater than that of the overall market, its Beta will be greater than 1. If it has a lower risk, then its Beta is less than one. A treasury bond, for example, is traditionally perceived as having a Beta of 0 because there’s no risk.
Market Risk Premium will represent the asset’s return beyond more than just the Risk-Free Rate. This premium is an added return that can further convince potential investors to put capital into a riskier investment, asset, or security.
Investors use the capital asset pricing model to see if a riskier investment is worth their time. A risky stock, for example, won’t always yield more than a stock with less risk. But CAPM is a great way to discern between riskier stocks that do have a potentially higher yield.
Example Of Capital Asset Pricing Model Application
Let’s say you’re getting into some of the more areas of advanced stock trading and are considering purchasing some stock at $100 per share. Let’s also assume that this stock pays a 3% annual dividend. You want to invest a lot of money in this stock, but not before you get an idea if the risk is worth the reward.
Because we need a Risk-Free Rate, let’s assume the 10-year yield of a Treasury bond is 3%. Furthermore, you expect the market to go up by 5% per year as the economy will likely bounce back over the next few years.
Based on your CAPM calculations, the Expected Return Rate of this potential stock investment is 6%. The Beta of this stock is a little bit risky, with a value of 1.5
6% = 3% + 1.5 ( 5% – 3% )
The stock’s appreciation over a period of time and the stock’s expected dividends are discounted by the Expected Return. If the discounted value of the future cash flow is equal to or greater than the $100 per share price, then the capital asset pricing model says this is definitely an investment you should be taking advantage of.
Risky Investing Statistics and Why We Need to Understand the Capital Asset Pricing Model
It seems that the younger and middle-aged generations are the ones that will benefit greatly from the Capital Asset Pricing Model. According to a recent study that shows a person’s willingness to take above-average or substantial investment risks, Millennials and Gen-X’ers were more likely to take the plunge into conducting risky business than Baby Boomers and people from the Greatest Generation.
That certainly makes sense. The greatest Generation was affected by the Great Depression and, at the very least, the second world war. This caused them to be very cautious with their money. Baby Boomers learned to heed the same caution from their parents and were in a much better economy at a time when substantial risks weren’t necessary.
The capital asset pricing model gives you a simple calculation you can use to gauge whether the potential reward is worth the perceived investment risk. It’s also a great way to teach new investors about the importance of diversification. By hedging your stocks against risk, you can limit your overall portfolio loss should high-risk security not do well.
As of mid-2020, about 56% of all US households have some stake in the stock market. Maybe you are just playing around or investing for retirement, or maybe all your earnings are stuck in the market. Regardless of how much you have invested, CAPM is a great way to understand the risks associated with various investments.
Pros and Cons of the Capital Asset Pricing Model
In the magical land of financial modeling, CAPM plays many important roles. First, it gives you a relatively simple way to calculate a potential return on investment while accounting for any potential risks involved. You can also calculate your portfolio’s health and risk to see if it needs rebalancing from time to time. Second, the easy-to-use calculation gives investors a better understanding of risk versus reward regarding specific investments.
There are plenty of financial advisors and analysts who don’t like the capital asset pricing model. They say it creates unrealistic expectations about an investment’s potential future performance. For example, when calculating CAPM using Beta, a swing in value, either up or down, isn’t considered and doesn’t hold equal risk. On top of that, risk and rewards don’t distribute evenly over time. This means that calculating CAPM for a specific time period won’t account for this uneven distribution.
The CAPM can also assume the risk-free rate is constant, which isn’t the case with every asset and every investment. So, for example, using the S&P 500 (or a similar stock index), CAPM will only suggest a theoretical value even though the S&P 500 will probably perform differently over time. This is why CAPM only gives you a suggestion and not an exact calculation with a definitive answer.
Origins of the Capital Asset Pricing Model
The very basics of the Capital Asset Pricing Model date back to Harry Markowitz’s ideas from his 1952 book Modern Portfolio Theory. John Lintner, Jan Mossin, Jack Treynor, and William F. Sharpe put their heads together and joined forces to create the foundation for the CAPM model that’s used today.
In 1972, an economist named Fischer Black created a version of CAPM that assumes an asset cannot exist without risk. This is called the Black CAPM. However, it wasn’t until financial institutions started using his Black CAPM model that the original CAPM model, created by the 4 economists back in the 60s, gained popularity.
CAPM Systematic Risk and Unsystematic Risk
A risk that affects a specific asset, company, or stock is known as unsystematic risk. This type of risk can partially be avoided by hedging and diversification. Whenever you hedge, you use a different investment (or group of investments) to offset any potential negatives against the asset with unsystematic risk. Some examples of unsystematic risk include upper management issues, strikes, and shortages of raw materials.
On the other hand, systematic risk is not related to one specific asset, stock, security, or company. Instead, systematic risk is completely market-related and is nearly impossible to defend against by hedging or diversification. Examples of systematic risk can include everything from overall interest rate changes to major wars.
A recession is a good example of systematic risk. Hedging or diversifying won’t help protect you from systematic risk. Think about the Great Depression. It didn’t matter what stock you held; you were going to lose big during that time.
Originally, CAPM aimed to protect only against unsystematic risks. However, today, the evolution of the capital asset pricing model aims to measure any risks, including systematic risks.
CAPM = Investors’ Compensation
To sum it up, you always want to be fairly compensated for taking a chance on putting your money in a risky investment. This compensation can come in the form of higher yields. CAPM helps us determine whether or not a risky investment has enough potential payoff to make this investment worthwhile.