Investing in yourself is a risky proposition and if you decide to accept it without a good knowledge of the risk and reward involved, it can amount to a blind person fumbling around.
To make informed decisions, investors can subscribe to reports from a reputable investment firm or to advice from a trust broker. Some may even prefer to trust their instincts after gaining a “feel” for market psychology due to the fact that they have been in the business for a long time.
While all of the above are legitimate practices, described below is a more scientific DIY technique. While it might seem as foreign as a foreign language at first, taking the time to understand the theory and put it into practice can help familiarize investors with this DIY model.
Related link: General conditions of sale: what is a BDC?
CAPM-Applications
The Capital Asset Pricing Model, or CAPM, is a model used for:
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Calculate the expected rate of return on an asset taking into account knowledge of the risk associated with the asset.
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Calculate the cost of capital.
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Determine the price of a risky asset.
Logic behind the model
The returns received are a direct function of the risk taken. The higher the risk you take, the greater your returns.
The formula
ra = rrf + Ba (rm-rrf)
Essentially, the expected return is equal to the return on a risk-free asset plus a risk premium.
where ra – required rate of return for an asset
Ba – the risk coefficient of the asset
rm – expected market returns
Now for the values ââof each of the metrics on the RHS of the equation:
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Treasury bills, which are relatively safe investment options, are considered risk-free assets. Thus, the yields of Treasury bills / bills of appropriate maturity depending on the time horizon of our investment are used for the purpose of calculating the returns of a risk-free asset.
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The returns of the S&P 500 Index or any other credible representative index could be used to calculate expected market returns.
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That leaves us with beta, which measures volatility. One can use the beta values ââprovided by reputable analysts or websites or calculate them personally, the second option being tedious.
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A security with beta> 1 is more volatile than the market and therefore risky and on the contrary, one whose beta is
An example
Assuming the risk-free return is 5% and the market return is 8% and the beta of the asset is 1.5, the expected rate of return on the asset can be calculated using the using the CAPM model.
Expected return on assets = 2 + 1.5 * (8-2)
= 2 + 9
= 11%
Good investment, guys!
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