Category Archives: Personal Finance

what is CAPM

What is CAPM?

Capital Asset Pricing Model is rationalized by modern portfolio theory to determine the fair value of an asset. Due to it’s reliance on assumptions on an investors behaviours, the distributions of risk and returns it’s measurements are open to scrutiny from independent analysis. Therefore, when using the CAPM to evaluate your portfolio model, you should have a third party evaluate your analysis. The principles of CAPM and the efficient frontier allows you to set expectations when you place assets in your portfolio, in particular correlations between the return on investment for high risk assets.

What is the CAPM?

Poses to explain the correlation between identifiable risk and expected return of an asset or particular-kind of assets within the sector or wider market. It is an attractive method of pricing assets and attributing return on investment to riskers assets within the market.

CAPM Explained

CAPM

So as ER = expected return on investment and
Rf = the risk-free rate
Bi = Beta of the investment
(ERM – RF) = market risk premium

The first assumption that you should present is that you are to be compensated for TVM of a minimum and secondly that you will be rewarded for taking on the risk since the risk-free rate accounts for TVM.

The market beta for the asset shows the risk of the asset and the impact of that risk the asset will have when added to the portfolio, in addition to the risk considered vs the overall market. For a beta greater than 1.0, it has a higher risk than the wider market and therefore should attract greater returns. For a Beta with less than 1.0 it should provide lesser returns but grant stability to the portfolio.

The Beta Coefficient

The Beta Coefficient

What is Beta?

The beta coefficient is a form of measurement for volatile movement in an individual stock, as well as systematic risk in comparison to comparable stocks or the wider market. Beta is a representation of the trajectory output of the slop calculated through regression analysis of a particular stock vs sector vs wider market.

Beta Formula (How to calculate Beta)

Re = Return on individual stock

Rm = Return on the Market.

Covariance = how changes in a stock’s returns are related to changes in the market’s returns.

Variance = how far the market’s data points spread out from their average value.

The Beta Coefficient
The Beta Coefficient

Applying (B) Beta

When a security experiences price movement ‘rubber banding’ or ‘swings’, beta justifies this activity.

You can measure Beta in three steps:

  • Identify the target of the covariance;
  • Divide the covariance against the variance of the market;
  • Over defined period;

This calculation is used to measure if there was any movement of the stock against the wider market, including the volatility-risk in comparison to its sector or wider market.

The target return used in the beta calculation must be related to the particular stock, as an investor you would be trying to ascertain the risk of that particular stock and the effect of that risk to your wider portfolio. If the stock has a strong deviation from the market, then it would add a lot of risk to your portfolio but could also provide greater return potential in comparison to lesser risk investments.

Why index funds out perform active funds

Why index funds outperform active funds

The efficient market hypothesis originated from an empirical observation on the activity within the stock market, in particular the consistency of individual stocks out performing active managers.

This observation documented the obvious data points on the price movement of these stocks’ vs active managers. Hence why in 1965, everything changed within financial securities market and not just for Eugene Fama.

Investors were instilled with a new sense of confidence having been told by their accountants, financial advisors, friends, family, colleagues and radio that they could have success in the stock market because the efficiency of a particular firms pricing is not necessarily determined on the basis of a company’s fundamental indictors but on the assumption that:

Because all market participants have the same access to the same information, the prediction of price movement is not a necessary exercise. Instead, investors should diversify their investments, taking advantage of market anomalies (anomalies in price movement are often attributed to legal, political and economic risks).

It is on this basis that any investor who diversifies their portfolio and makes purchases in stocks with the intention of long-term investment would outperform active managers.

What about the capital asset pricing model contradiction?

The expectation of anomalies within the EPH is consistent with prediction of price movement with stocks identified as “under-valued” in activities known as value investing.

An example of value investing would be identifying stocks within the ASX 200 and ASX 300. These stocks would then be subject to fundamental analysis and using the relative valuation models which is done by comparing the profit to equity ratio of companies within the same sector to ascertain the perceived value of the company vs the “actual value”.


Absolute valuation is an analysis based of the fundamental indicator of that particular stock and comparing companies with similar activities.

The obvious criticism of value investing is that because every stock is different many, its not possible to have success by following the same strategy for analysis when attempting to make a prediction.

The partial defense to this criticism is that because it has been identified as undervalued the question changes from “if there is a price movement” to “when there will be a price movement”, this question then becomes further scrutinized through volatility analysis, which makes semi-accurate prediction within the immediate short-term but is not as useful in the long term.


But as always, “No guarantees”.