Investing at its own risk. But there are strategies for determining the expected return on an investment, based on that risk. This is called the Capital Asset Valuation Model (CAPM).
Investors can use CAPM to determine if an investment is worth the risk. Learn how to calculate it and how to use it in your investment.
Fixed asset pricing model: the basics
The Capital Asset Pricing Model is widely used in the financial industry, especially for riskier investments. The model is based on the idea that investors should obtain higher returns when investing in riskier investments, hence the presence of the market risk premium in the model formula.
Expected return = risk-free rate + (beta x market risk premium)
Using the fixed asset valuation model, the expected return is what an investor can expect to earn on an investment over the life of that investment. This is a discount rate that an investor can use to determine the value of an investment. The risk-free rate is the equivalent of the yield on a 10-year US government bond, although if the calculation is done in another country, it should use the yield on that government’s 10-year bond.
Beta is the representation of a stock’s risk, generally its sensitivity to changes in the market. If a stock’s risk exceeds the market, its beta is greater than one. If its beta is less than one, it can reduce the risk within your portfolio.
Finally, the market risk premium represents the return on an asset beyond the risk-free rate alone. The market risk premium is an additional return that can encourage investors to invest capital in riskier investments.
Risky investments can be attractive to investors if the return rewards them for their time and tolerance for risk. The CAPM assesses whether the value of a stock is worth this risk or not.
CAPM in action
For example, suppose you are looking at a stock worth $ 50 per share today that pays an annual dividend of 3%. The stock’s beta to the market is 1.5, which makes it riskier than a market portfolio. Let’s also assume that the risk-free rate is 3% and this investor expects the market value to increase by 5% per year.
The expected return on the share based on the CAPM is 6%.
6% = 3% + 1.5 Ã (5% â3%)
This expected return reduces the expected dividends of the share and the appreciation of the share during the expected holding period. If the present value of future cash flows equals $ 50, CAPM says the stock is priced right for its risk.
William Sharpe, economist and Nobel laureate, designed CAPM for his 1970 book Portfolio theory and capital markets. He notes that an individual investment involves two types of risks:
Systematic risk: In other words, a market risk that portfolio diversification cannot correct. Interest rates, recessions and wars are examples of systematic risks.
Unsystematic risk: This âspecific riskâ concerns a specific company or sector. Strikes, mismanagement or the shortage of a necessary component in the manufacturing process are all considered unsystematic risks.
Unsystematic risk, or specific risk, is what modern portfolio theory targets when it suggests diversification of a portfolio. However, diversification does not address systematic risk. CAPM exists to measure systematic risk.
Advantages and disadvantages
The fixed asset valuation model is important in the world of financial modeling for several key reasons. First, by helping investors calculate the expected return on an investment, it helps illustrate how sound a particular investment can be. Investors can use the CAPM to assess the health and rebalancing of their portfolio, if necessary.
Second, it is a relatively simple formula that is quite easy to use. In addition, 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 is also one of the rare formulas which takes systematic risk into account.
Critics of CAPM say it is making unrealistic assumptions. For example, the beta does not recognize that price fluctuations in both directions do not present the same risk. In addition, the use of a particular time period for risk assessment ignores the fact that risks and rewards are not distributed evenly over time.
The CAPM also assumes a constant risk-free rate, which is not always the case. A 1% increase in Treasury bill interest rates would significantly affect this investment. Meanwhile, using a stock index like the S&P 500 only suggests a theoretical value. This index might work differently over time.
The bottom line
While the fixed asset valuation model is not without its drawbacks, it remains a key tool for investors.
They can use the CAPM to determine whether an investment is worth the risk.
The potential benefits of CAPM include ease of use and calculating the rate of return on a riskier investment. However, critics say the CAPM has many incorrect assumptions. It’s not perfect, but CAPM can still be a useful tool in assessing risk.
If you don’t know how to diversify your portfolio, a financial advisor can help. Finding the right financial advisor for your needs doesn’t have to be difficult. SmartAsset’s free tool connects you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors who will help you reach your financial goals, start now.
Have you determined the level of investment risk you are prepared to take? Do you know how much your investment must grow to reach your goals? Have you considered how much inflation and capital gains tax will take out of your investment. SmartAsset’s Investment Guide can help you understand these key first steps to a successful investment.
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The publication The Capital Asset Pricing Model, Explained first appeared on the SmartAsset blog.