 Personal Finance PowerPoint Presentation, Capital Asset Pricing Model CAPM. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia Capital Asset Pricing Model CAPM, which you can find online. Take a look at the references, resources, continue your research from there. This by Will Kenton updated August 4th, 2022. In our prior presentations, we've been looking at investment goals, strategies, tools, keeping in mind the two major categories of investments, typically being the fixed income, bonds oftentimes, or the equity often being the common stock. Also, keep in mind the tools that you are using, which might include things like mutual funds and ETFs, and your time horizon, how long you have to invest. If using tools like mutual funds and ETFs to diversify your portfolio, you might be using different strategies than if investing in individual stocks, in which case you might be drilling down to the financial statements themselves doing ratio analysis and trend analysis from individual stocks. Keeping that in mind, we're asking the question, what is the Capital Asset Pricing Model? The Capital Asset Pricing Model describes the relationship between the systematic risk or the general perils of investing and expected returns for assets, particularly stocks. We're generally focused kind of more on the equity on the stocks side of things and trying to take into consideration the systematic risk and the perils of investing within our investment decisions as well as comparing that to the expected returns we hope to be having in the future. So the CAPM evolved as a way to measure this systematic risk. It is widely used throughout finance for pricing risky securities and generated expected returns for assets given the risk of those assets and cost of capital. Understanding the Capital Asset Pricing Model, the CAPM, the formula for calculating expected return of an asset given its risk is as follows. We've got our formula up top, so the ER is the expected return of investment is equal to the risk-free rate and then we have that added to the beta of the investment calculated here times the ER minus the RF, which is the market risk premium. We might do some examples on this one in our practice problem to drill down on it in a little bit more depth, but we'll get it conceptually based on the conception a little bit more here. Investors expect to compensate for risk and the time value of money. So when we're investing clearly, we've got the time value of money because the money today is worth more than money tomorrow, so we want to take that into consideration and then of course we want to generate return in the future and we have to factor in the risk related to it as well and those combinations can be a little bit more confusing than you would think with a few combinations to determine what the best investments would be for a particular investment and how it might fit into, for example, our overall portfolio. So the risk-free rate and the CAPM formula accounts for the time value of money. The other components of the CAPM formula account for the investor taking on additional risk. So the time value of money risk, we're going to say that's our standard rate that we're going to use for time value of money calculations and then we might have other risk or additional risks that we want to factor in. Any other risks that we have or any risk that we have, of course, we want to put that in the formula to help us with our numerical decision-making problem, taking these risks and trying to break them down into numbers that we can compare. So the beta of a potential investment is a measure of how much risk the investment will add to a portfolio that looks like the market. So we've talked about beta calculation in a prior presentation. If a stock is riskier than the market, it will have a beta greater than one. If a stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio. A stock's beta is then multiplied by the market risk premium, which is the return expected from the market above the risk-free rate. The risk-free rate is then added to the product of the stock's beta and the market risk premium. The result should give an investor the required return or discount rate they can use to find the value of an asset. The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and the time value of money are compared with its expected return. So we're always kind of comparing the expected return because we're looking into the future and the risk related to it. In other words, it is possible by knowing the individual parts of the CAPM to gauge whether the current price of a stock is consistent with its likely return. For example, imagine an investor is contemplating a stock value at $100 per share today that pays a 3% annual dividend. The stock has a beta compared to that of the market of 1.3, which means it is riskier than a market portfolio. Also, assume that the risk-free rate is 3%, so that's taking into consideration the time value of money so that you might think like inflation, for example. And this investor expects the market to rise in value by 8% per year. The expected return of the stock based on the CAPM formula is 9.5%. 9.5% is equal to the 3% plus the 1.3 times the 8% minus the 3%. The expected return of the CAPM formula is used to discount the expected dividends and capital appreciation of the stock over the expected holding period. If the discounted value of those future cash flows is equal to $100, then the CAPM formula indicates the stock is fairly valued or relative to risk. So problems with the CAPM there are several assumptions. So obviously, whenever we're trying to figure out what's going to happen into the future, we're making assumptions. So what are those assumptions? When would those assumptions hold? What are circumstances in which those assumptions may not hold and let's be aware of those? So there are several assumptions behind the CAPM formula that have been shown not to hold up in reality. Modern financial theory rests on two assumptions. One, securities markets are very competitive and efficient. That is, relevant information about companies is quickly and universally distributed and absorbed. So in other words, the idea of markets, you think that markets are pretty chaotic things, but they're actually much better at gauging prices than say a bureaucratic centrally governed area, for example. However, there's going to be debate in terms of how good is the market at basically putting it into the market price everything that should be included in the market price. Some people think that the markets work very efficiently and move towards equilibrium quite quickly and have therefore relevant or good pricing priced in pretty much all the time. Other people say no, there's some information that some people have that other people don't have and it takes time. There's more kind of slowness or stickiness to the market. So although the markets are more efficient than having someone just a centralized governorship of something, it still has stickiness and therefore you can't just depend on the price to be the price just because there's a market would be the idea. And two, these markets are denominated by rational risk averse investors who seek to maximize satisfaction from returns on their investments, meaning the people investing in the markets if you had all the information that you were a rational risky averse investor then those are the people making the decisions. In other words, a classical economic model would be we've got rational people may having all the information they need in order to make relevant decisions and that's why the markets drive till equilibrium. And other people would argue, well no, a lot of people aren't exactly rational, they're emotional based and they're going to be making decisions emotionally and therefore although we're still going to be more efficient in a market maybe it's not quite as efficient, it's not exact equilibrium of where it kind of should be all the time based on underlying values. Okay, as a result, it's not entirely clear whether CAPM works. The big sticking point is beta. So we talked about beta in prior presentations and calculating it. When Professor Eugene Fima and Kenneth French looked to share returns on the New York Stock Exchange, the American Stock Exchange and NASDAQ they found that differences in betas over a lengthy period did not explain the performance of different stocks. The linear relationship between beta and individual stock returns also breaks down over shorter periods of times. These findings seem to suggest that CAPM may be wrong. Despite these issues, the CAPM formula is still widely used because it is simple and allows for easy comparison of investment alternatives. In other words, obviously you have to have some kind of gauge that you're going to be gauging if you're picking and choosing and then of course you want to think about the areas where that formula might not be the most appropriate. We've talked about different strategies for gauging the markets and so on. You might try to look at the underlying financials and so on and then look at trends and this kind of thing. But in any case, including beta in the formula assumes the risk can be measured by a stock's price volatility. This is one of the strategies in the market in order to basically take this into consideration. However, price movements in both directions are not equally risky. The look-back period to determine a stock's volatility is not standard because stock returns and risk are not normally distributed. Remember we talked about this idea of a normal distribution like a bell curve type of distribution. Oftentimes we're assuming if we assume a bell curve distribution when the distribution is not really actual bell shaped in terms of the actual data we're going to come to assumptions that are possibly not right. These are things that if you read the Black Swan guy, he gets into a lot of the statistical analysis on these assumptions. I think Taleb is his name that are saying there's times when these models don't quite work. But obviously again you've got to know the models to know when they don't work if you're really diving into this stuff and try to see when and why certain assumptions don't work and then account for that within your model possibly building more complex models at that point. So including beta in the formula okay I looked at that so the CAPM also assumes that the risk-free rate will remain constant over the discounting period. Assume in the previous example that the interest rate on US Treasury bonds rose to 5% or 6% during the 10-year holding period and increase and the risk-free rate also increases the cost of the capital used in the investment and could make the stock look overvalued. The market portfolio used to find the market risk premium is only a theoretical value and is not an asset that can be purchased or invested in as an alternative to the stock. Most of the time investors will use a major stock index like the S&P 500 to substitute for the market so now you're using an index which is basically an average in and of itself to substitute as the market which is in perfect comparison of course because it's just an index which is like an average trying to get a sample that will give you an idea of the market as a whole. So the most serious critic of the CAPM is the assumption that future cash flows can be estimated by the discounting process. So remember when we're trying to value something if we try to value bonds the way we come up with bonds we can say okay the bond is straight forward. It's got future cash flows that are interests which are an annuity in essence and then that lump sum at the end which we can basically discount back. We can try to use the same idea for stocks but it's a little bit more complex because the stocks were expecting future value from one dividends which are the return of capital but those things change depending on what the board of director wants to do and two they might hold on to the dividends and then try to increase the stock price rather than give out the dividends. So they might give out dividends eventually but now we've got a little bit more complex model in terms of what are the future cash flows that are going to be that we're going to be discounting back in order to get the price or value of the stock. Also there's no maturity for stock they go on forever. So those things obviously make this discounting assumptions a little bit more complex. If an investor could estimate the future return of a stock with a high level of accuracy the CAPM would not be necessary. So the CAPM the effect frontier using the CAPM to build a portfolio is supposed to help an investor manage their risk. If an investor were able to use the CAPM to perfectly optimize a portfolio's return relative to risk it would exist on a curve called the efficiency frontier as shown in the following graph. Now if you see if you seen like economics you might have seen like a production frontier the most efficient efficient place would be basically on this market line right and so they're going to say that the ideal market portfolio according to this graph would be at this point in time and this is basically the efficiency frontier in essence this curve here anything below this line is something that isn't as optimal or as efficient anything outside it might say would be something not likely or impossible kind of place to be generally general those are general concepts of it. So the graph shows how greater expected returns y-axis require greater expected risk x-axis and that's the general case because risk more risk the more expected return you want to be taken on. Modern portfolio theory MPT suggested starting with the risk free rate the expected return of a portfolio increases as the risk increase so any portfolio that fits into the capital market line the CML is better than any possible portfolio in the right of that line but at some point a theoretical portfolio can be constructed on the CML with the best return for the amount of risk being taken. So the CML and efficient frontier may be difficult to define but they illustrate an important concept for the investor there is a tradeoff between increased return and increased risk because it isn't possible to perfectly build a portfolio that fits on the CML it is more common for investors to take on too much risk as they seek additional returns and this is obviously something that we want to be careful of because clearly there's a huge temptation it basically comes back to the idea of diversity. We want to have a diversified portfolio but if we have a diversified portfolio during good times we're probably not putting our money in the stocks that are really climbing at that point in time we feel like we're losing returns that we could otherwise get so we want to shift all our money to risky returns which people are getting at this point in time but when you do that then you're taking on more risk than those returns might warrant and in the event of a downturn you're going to get hit harder possibly than you otherwise would so again just acting out that concept of a balanced portfolio can be difficult in practice so in the following chart you can see two portfolios that have been constructed to fit along the efficiency frontier portfolio A is expected to return 8% per year and has a 10% standard deviation or risk level portfolio B is expected to return 10% per year and has a 16% standard deviation so 16% deviation meaning more risk or volatility generally so the risk of portfolio B rose faster than its expected return so now we've got the risk increasing faster than the expected returns we've got both of these on the actual curve but as we move out as we move out here right you can see that now you're increasing the expected return by this portion but you're increasing the risk by a whole lot more than the expected return so the efficient frontier assumes that some things as the CAPM can only be calculated in theory if a portfolio exists on the efficient frontier it would be providing the maximal return for its level of risk however it is impossible to know whether a portfolio exists on the efficient frontier so this kind of a theoretical concept because future returns cannot be predicted so this trade off between risk and return applies to the CAPM and the efficient frontier graph can be rearranged to illustrate the trade off for individual assets in the following chart you can see that the CML is now called the security market line SML instead of expected risk and the x-axis and the stocks beta is used as you can see in the illustration as beta increases from one to two the expected return is also rising so now we've got the expected return and beta on the x so clearly we've got the risk that we've got the the security market line and as we see the expected return going up we can see the beta increasing as well the CAPM and SML make a connection between a stocks beta and its expected risk beta is found by statistical analysis we talked about this in a prior presentation of individual daily share price returns in comparison with the markets daily returns over precisely the same period so a higher beta means more risk but a portfolio of high beta stocks could exist somewhere on the CML where the trade-off is acceptable if not the theoretical ideal the value of these two models is diminished by assumptions about beta and market participants that aren't true in the real markets so for example beta does not account for the relative riskiness of a stock that is more volatile than the market with a high frequency of downside stocks compared with another stock with an equally high beta that does not experience the same kind of price movements to the downside so again I think that basically is saying that you've got this bell shaped kind of distribution concept again so when you look at the volatility you're kind of making your calculation as if the data is bell shaped but you might not have an actual bell shape distribution which means your assumptions could be skewed so practical value of the CAPM considering the critiques of the CAPM and the assumptions behind its use in portfolio construction it might be difficult to see how it could be useful however using the CAPM as a tool to evaluate the reasonableness of future expectations or to conduct comparisons can still have some value so imagine an investor who has used adding a stock to a portfolio with a $100 share price the investor uses the CAPM to justify the price with a discount rate of 13% the investor's investment manager can take this information and compare it with the company's past performance and its peers to see if 13% return is reasonable expectation so assume in this example that the peer group's performance over the last few years was a little more than 10% while this stock had consistently underperformed with 9% returns the investment manager shouldn't take the investor's recommendation without some justification for the increased expected return so obviously we've got to make some assumptions somehow if we're trying to predict in the future what's going to happen and justify our decisions so an investor also can use the concepts from the CAPM an efficient frontier to evaluate their portfolio or individual stock performance versus the rest of the market for example assume that an investor's portfolio has returned 10% per year for the last 3 years with a standard deviation risk of 10% however the market averages have returned 10% for the last 3 years with a risk of 8% so the investor could use this observation to reevaluate how their portfolio is constructed and which holding may not be on the SML this could explain why the investor's portfolio is to the right of the CML if the holdings that are either dragging on returns or have increased the portfolio's risk disproportionately can be identified the investor can make changes to improve returns so not surprisingly CAPM contributes to the rise in the use of indexing or assembling a portfolio of shares to mimic a particular market or asset class we're trying to do a statistical analysis kind of taking a sample to get an idea of the whole class itself by risk averse investors so this is largely used to CAPM's message that it is only possible to earn higher returns than those of the market as a whole by taking on high risk beta so what's the bottom line CAPM uses a principle of modern portfolio theory to determine if a security is fairly valued it relies on assumptions about investor behavior, risk and return distributions and market fundamentals that don't match reality however the underlying concepts of CAPM and the associated efficient frontier can help investors understand the relationship between expected risk and reward as they strive to make better decisions about adding securities to a portfolio