Investing has its risks. But there are strategies to determine an investment’s expected return, based on that risk. It’s called the Capital Asset Pricing Model (CAPM). Investors can use CAPM to determine whether an investment is worth the risk. Learn how to calculate it and use it in your investing.
Capital Asset Pricing Model: The Basics
The Capital Asset Pricing Model is widely used within the financial industry, especially for riskier investments. The model is based on the idea that investors should gain higher yields when investing in more high-risk investments, hence the presence of the market risk premium in the model’s formula.
Expected return = Risk-free rate + (beta x market risk premium)
Using the capital asset pricing model, the expected return is what an investor can expect to earn on an investment over the life of that investment. It is a discount rate an investor can use in determining the value of an investment. The risk-free rate is the equivalent of the yield of a 10-year U.S government bond, though if the calculation is being done in another country, it should use that government’s 10-year bond yield.
Beta is the representation of a stock’s risk, usually how susceptible it is to changes in the market. If a stock’s risk outpaces the market, its beta is more than one. If its beta is less than one, it can reduce risk within your portfolio.
Lastly, the market risk premium represents an asset’s return beyond just the risk-free rate. The market risk premium is an added return that can entice investors to put capital into riskier investments.
Risky investments can be worthwhile to investors if the return rewards them for their time and risk tolerance. CAPM evaluates whether or not a stock’s value is worth that risk.
CAPM in Action
For example, say you’re looking at a stock worth $50 per share today that pays a 3% annual dividend. The stock’s beta compared to the market of 1.5, making it riskier than a market portfolio. Also, assume that the risk-free rate is 3% and this investor expects the market to rise in value by 5% per year.
The expected return of the stock based on CAPM is 6%.
That expected return discounts the stock’s expected dividends and appreciation of the stock over the expected holding period. If the discounted value of future cash flows is equal to $50, CAPM says the stock has a fair price for its risk.
History of CAPM
William Sharpe, an economist and Nobel Laureate devised CAPM for his 1970 book Portfolio Theory and Capital Markets. He notes that an individual investment contains two kinds of risk:
- Systematic Risk: In other words, market risk that portfolio diversification can’t fix. Interest rates, recessions, and wars are examples of systematic risks.
- Unsystematic Risk: This “specific risk” relates to a specific company or industry. Strikes, mismanagement, or shortage of a necessary component in the manufacturing process all qualify as unsystematic risk.
Unsystematic risk, or specific risk is what modern portfolio theory targets when it suggests diversification of a portfolio. However, diversification doesn’t address systematic risk. CAPM exists for measuring systematic risk.
Pros and Cons
The Capital Asset Pricing Model is important in the world of financial modeling for a few key reasons. Firstly, by helping investors calculate the expected return on an investment, it helps illustrate how sound a particular investment might be. Investors might use the CAPM for gauging their portfolio’s health and rebalancing, if necessary.
Secondly, it’s a relatively simple formula that’s fairly easy to use. Additionally, the CAPM is an important tool for investors when it comes to accessing both risk—such as that associated with riskier investments—and reward. It’s also one of the few formulas that accounts for systematic risk.
CAPM’s critics say it makes unrealistic assumptions. For instance, beta doesn’t acknowledge that price swings in either direction don’t hold equal risk. Also, using a particular period for risk assessment ignores that risk and returns don’t distribute evenly over time.
The CAPM also assumes a constant risk-free rate, which isn’t always the case. A 1% bump in treasury bond interest rates would significantly affect that investment. Meanwhile, using a stock index like the S&P 500 only suggests a theoretical value. That index could perform differently over time.
The Bottom Line
While the capital asset pricing model isn’t without its downfalls, it remains a key tool for investors. They can use the CAPM to determine whether an investment is worth the risk.
The potential upsides of the CAPM include ease of use and calculating a riskier investment’s rate of return. However, critics say CAPM carries loads of inaccurate assumptions. It isn’t perfect, but CAPM still can be a useful tool for assessing risk.
- If you’re not sure how to diversify your portfolio, a financial advisor may be able to help. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Have you figured out how much investment risk you’re willing to take on? Do you know how much your investment needs to grow to reach your goals? Did you look into how much inflation and capital gains tax will take out of your investment. SmartAsset’s investing guide can help you figure out these key first steps toward successful investing.
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