Explore how CAPM can assess expected returns and guide your investment choices. Let’s unravel the mystery.
They say that in life, we must always take calculated risks, and hence no matter where we go, be it an adventurous ride or venturing into the exciting world of stocks, the question of risk versus reward always looms large.
That’s why before saying yes to any investment, we often pause and wonder: Is the return and price worth the risks involved?
But how do we make this analysis? Some investors rely on guesswork, while others examine past performance. But hold on! There’s a logical model that can help you calculate the expected rate of return based on the risk involved. This model is known as the ‘Capital Asset Pricing Model’.
What is the Capital Asset Pricing Model?
The Capital Asset Pricing Model (CAPM) is a model that helps investors understand the expected return they should receive for taking on a certain level of risk when investing in an asset, such as stocks. It considers the asset’s sensitivity to overall market fluctuations and the risk-free rate of return. In simple terms, CAPM helps us evaluate whether the potential return justifies the risk we take while investing in a particular asset.
Remember that CAPM does not guarantee returns, but it is a logical model that indicates how much you should expect in return for your risk.
Before you get overwhelmed, let’s break the concept down with a simple example.
Imagine a bank offering you a fixed deposit (FD) with a safe return of 6% annually. This is a risk-free return since bank FDs are considered safe.
Now, a mutual fund offers an average return of 6% per year as well. However, this mutual fund carries a medium level of risk. Would you invest in this fund and take on more risk for the same return? Probably not.
But what if the mutual fund offered an average return of 12% annually? Now, things look more attractive because you would earn 6% more return than a risk-free investment by taking on a little more risk.
This additional 6% return is called the ‘risk premium’. It represents the extra return you receive for taking on additional risk.
Now, let’s consider another investment where there is a single stock named ‘X’. Since this investment is not diversified and only represents one company, it carries even more risk. The question is, what return should you expect from stock ‘X’? This is precisely what the CAPM formula helps us determine. The percentage return it calculates is the cost of equity or expected rate of return for that particular investment.
Calculation of CAPM
The formula to calculate the expected return is as follows:
Expected Return (Ra) = Risk-Free Rate (Rf) + Beta (Market Return – Risk-Free Rate)
Now, let’s break down the formula:
- The expected return (Ra) is the return you should anticipate from the investment.
- The risk-free rate (Rf) is the rate of return offered by a safe investment like the 6% FD return mentioned earlier.
- Beta measures the volatility or sensitivity of a stock or asset to market movements. A beta value of less than one suggests lower volatility compared to the overall market, while a value greater than one indicates higher volatility. So if a stock’s beta is 1.5, it means that when the market offers a 10% return, the stock offers a 15% return.
- Market Return minus the Risk-Free Rate (Rf) represents risk premium or the expected return of the overall stock market minus the risk-free rate. This value is variable and depends on market conditions. For example, when the benchmark indices Nifty and Sensex show a considerable upward trend, the overall market return will be high and vice versa.
Now, let’s go back and calculate the return of stock ‘X’. Consider that it is trading at a beta of 1.1. And in the place of market return, let’s consider Nifty 50, which has offered a return of 22.68% in the past year, according to BQ Prime.
To calculate the return you should expect from stock ‘X’ for the risk you are taking, we use the formula: 6% + 1.1 (22.68% – 6%) = 24.35%.
So, based on the given information, you can anticipate an expected return of 24.35% from stock.
Similarly, calculating the expected return for any stock is easy. Also, you don’t have to sit and calculate the beta of the stock, as it can be found on various reliable financial websites. Also, CAPM calculators are also available online. So, before you invest, you can know how much returns to expect in just a few clicks.
Advantage of CAPM
Considers Systematic Risk as Well as Unsystematic Risk
When we invest in a stock, we look at the fundamentals and compare if one stock is better than another from the same sector. But what makes one company’s share price appreciate faster than the other? Well, this results from unsystematic or company-specific risk. Here, the share price is influenced by factors like the company’s financial performance, such as higher earnings per share (EPS), which can cause the stock price to rise and vice versa. These risks are diversifiable because they can be reduced by diversifying investments across different companies. For example, if one stock performs poorly, other stocks in the portfolio may balance it.
Then we have systematic risk or market risk. It is not specific to any particular company and affects the entire stock market. Factors like interest rates, inflation, and the overall state of the economy cause it. These factors impact all stocks and cannot be eliminated through diversification. For example, during the COVID-19 pandemic, stock prices fell regardless of good or bad financials. However, during normal market times, a stock’s price is more influenced by its underlying business fundamentals, especially profits. If a company’s profits increase, the stock price tends to follow the same trend.
So, the CAPM model considers both the concepts of systematic and unsystematic risk and helps investors assess the expected return, which justifies the level of risk involved.
Disadvantage of CAPM
Frequently Changing Variables
The beta of the stock and the overall market return can change frequently, which majorly affects the calculation of CAPM. Specifically, from a long-term perspective, the expected return may vary several times depending on the stock’s performance and market conditions.
In conclusion, CAPM has been widely used in the financial industry for many years, and some critics have claimed it is unreliable. Like any other model, CAPM has limitations that can affect its accuracy. For instance, it relies on historical data, which may not capture the complexities of the market accurately.
However, it is important to note that no model can perfectly predict the future, and CAPM still provides a valuable framework for understanding the relationship between risk and expected returns.
You can use it as a starting point for assessing investments alongside other analytical tools and qualitative factors to make more informed decisions.
*The article is for information purposes only. This is not an investment advice.
Note: This article was originally written by Teji Mandi for ET Markets.
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