Discover How to Maximize Your Investment Returns with CAPM Model — Unravel the Secrets of Smart Investing!
So let’s say you are scrolling through NASDAQ and searching for a golden stock to invest in which will give you a warm two-digit return, but you ask yourself, How much risk should I take for such a return? You wonder about the answer when your roommate asks how much return she can expect if she is willing to risk 5% of her investment.
One way is to define your risk-reward ratio based on your risk appetite and situation and follow it in all investments.
But every investment is different, factors change, market conditions change, and so you have to tweak your strategy to gain maximum returns.
Capital Asset Pricing Model (CAPM)
Here’s where Capital Asset Pricing Model (CAPM) saves us. CAPM shows the relation between the risk and the expected reward from an investment.
CAPM is one of the cornerstones of modern finance and has been instrumental in developing the theory of asset pricing. — Eugene Fama, Professor of Finance at the University of Chicago Booth School of Business
The basic idea behind CAPM is that investors require a higher return on more risk. This means that if you are investing in a risky asset, like stocks, you should expect a higher return than if you were investing in a less risky asset, like bonds.
CAPM Formula
The CAPM formula is expressed as:
Expected Return = Risk-Free Rate + Beta x (Market Risk Premium)
where:
- Expected Return is the expected return on the investment.
- Risk-Free Rate is the rate of return on a risk-free asset, usually a government bond or Treasury bill.
- Beta is a measure of the volatility of the investment to the overall market and represents the systematic risk of the investment.
- Market Risk Premium is the additional return, investors want if they are to invest in the stock rather than a risk-free asset.
Let’s simplify the formula so we can understand it intuitively.
Risk-Free Rate
If there was an investment that had no risk. You can never make a loss in such an investment. What would be the rate of return of such an investment?
The risk-free rate is the rate of return that investors can earn on a completely risk-free investment, such as a U.S. Treasury bill or bond. The risk-free rate is used as a baseline to calculate the expected return on a risky investment. In theory, investors should expect to earn at least the risk-free rate on any investment, with additional returns being required for taking on additional risk.
Market Risk Premium
But we are not investing in a risk-free investment, we are taking risks in our investments, so we should get higher returns than the risk-free rate (more risk = more profit). The market risk premium is the additional return that we demand investing in the stock market rather than a risk-free asset. It is the difference between a risk-free rate from the expected return on the overall market.
The market risk premium reflects the additional return that investors expect to earn for investing in the stock market rather than a risk-free asset, and is considered a measure of the overall risk of the market.
Beta
So let’s say you choose a stock and observed it for a couple of days. You noticed that if the NASDAQ goes up 0.5% then the stock also goes up by 0.5%. Wherever the NASDAQ goes the stock follows it by the same proportion. This relation between the individual stock and the overall market is expressed in numbers and is called Beta.
Beta is a measure of the volatility of a particular investment in the overall market. Beta is expressed as a number between 0 and 1, with a beta of 1 indicating that the investment is as volatile as the overall market, while a beta of less than 1 indicates that the investment is less volatile than the overall market. A beta of greater than 1 indicates that the investment is more volatile than the overall market.
The formula used to calculate beta is:
Beta = Covariance of the investment’s returns with the market’s returns / Variance of the market’s returns
The higher the beta, the higher the expected return investors will demand taking on the additional risk of the investment.
Advantages of CAPM:
- Provides a framework for estimating expected returns that takes into account the level of risk involved: If you’re thinking about investing your money, it’s important to consider the level of risk involved. CAPM can help you estimate the expected returns for different investments based on the amount of risk involved. This can help you make more informed investment decisions.
- Helps you make informed decisions about your portfolio by comparing the expected returns of different investments: When you’re building a portfolio of investments, it’s important to consider the expected returns of each investment. CAPM can help you compare the expected returns of different investments so you can choose the ones that are likely to provide the best returns.
- Can be used to determine whether an investment is worth the risk: When you’re considering investing in a particular stock or asset, you need to decide if the potential returns are worth the risk involved. CAPM can help you make this decision by estimating the expected returns based on the level of risk.
Disadvantages of CAPM:
- Assumes that all investors have the same expectations and risk preferences: CAPM assumes that all investors have the same expectations and are willing to take the same level of risk. In reality, this isn’t always the case. Different investors have different risk preferences and expectations, so CAPM might not always provide accurate estimates of expected returns.
- Assumes that markets are always efficient and that all available information is reflected in stock prices: CAPM assumes that markets are always efficient, meaning that all available information is reflected in stock prices. However, markets aren’t always efficient, and sometimes new information can take time to be reflected in stock prices. This can make it difficult to accurately estimate expected returns using CAPM.
- Requires accurate estimation of beta, which can be challenging and subject to error: To use CAPM, you need to accurately estimate the beta of the investment. Beta is a measure of the volatility of an investment compared to the overall market. Estimating beta can be difficult and subject to error, which can affect the accuracy of your expected returns.
When to use CAPM:
- When estimating expected returns for a single asset or portfolio: You can use CAPM to estimate the expected returns for a single investment or a portfolio of investments. This can help you make informed decisions about whether to invest in a particular asset or portfolio.
- When comparing the expected returns of different investments: CAPM can help you compare the expected returns of different investments so you can choose the ones that are likely to provide the best returns.
- When considering the risk of an investment: CAPM can help you estimate the expected returns of an investment based on the level of risk involved. This can help you decide if the potential returns are worth the risk.
When not to use CAPM:
- When markets are inefficient: If the market isn’t efficient, CAPM might not provide accurate estimates of expected returns. In this case, you might need to consider other factors when making investment decisions.
- When the risk of an investment cannot be accurately estimated: If you can’t accurately guess the risk involved in an investment, CAPM might not provide accurate estimates of expected returns.
- When you have different expectations or risk preferences: If you have different expectations or risk preferences than other investors, CAPM might not provide accurate estimates of expected returns for you. In this case, you might need to consider other factors when making investment decisions.
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This write-up is for informational purposes only. It does not serve the purpose of any legal advice. You are solely responsible for making your own investment decisions. If you choose to engage in such transactions with or without seeking advice from a licensed and qualified financial advisor or entity, then such decision and any consequences flowing therefrom are your sole responsibility.
