Investing in and of itself is a risky proposition and if you decide to take it up without sound knowledge of the risk and reward involved, it can be tantamount to a blind person groping his way around.
To make informed decisions, investors can subscribe to reports from a renowned investment firm or trust broker's tips. Some may even prefer going by their gut instincts after gaining a "feel" of the market psychology by virtue of being in the business for a long period of time.
While all of the above are legitimate practices, outlined below is a more scientific DIY technique. Although at the outset, it might sound as alien as a foreign language, taking some time to understand the theory and actually putting the theory into practice can help familiarize investors with this DIY model.
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The Capital Asset Pricing Model, or the CAPM, is a model used to:
- Calculate the expected rate return of an asset given the knowledge of the risk associated with the asset.
- Calculate the cost of capital.
- Determine the price of a risky asset.
Logic Behind The Model
The returns received are a direct function of the risk taken. Higher the risk you take, the greater your returns.
ra = rrf + Ba (rm-rrf)
Essentially, expected return is equal to returns of a risk-free asset plus a risk premium.
where ra — required rate of return for an asset
Ba — the risk coefficient for the asset
rm — expected returns of the markets
Now for the values of each of the metric on the RHS of the equation:
- Treasuries, which are relatively safe investment options are considered as risk free assets. So, returns of treasury bond/bill of appropriate maturity depending on the time horizon of our investment is used for the purpose of calculating returns of a risk free asset.
- The returns of the S&P 500 Index or any other credible representative index could be used for calculating the expected market returns.
- That leaves us with beta, which measures the volatility. One can make use of the beta values provided by reputed analyst or websites or personally calculate it, the second option being tedious.
- A security with beta>1 is more volatile than the market and hence is risky and on the contrary, one whose beta is <1 is less volatile.
Assuming the risk-free return is 5 percent and the market return is 8 percent and the beta of the asset is 1.5, the expected rate of return of the asset can be calculated using the CAPM model.
Expected return of the asset = 2 + 1.5 * (8-2)
= 2 + 9
- = 2 + 1.5*6
Happy investing, folks!
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