Institutional and individual investors always diversify portfolio to manage risk. Portfolio management theories can help investors in this regard. Investor faces two types of risk:
- Systematic Risk – Otherwise known as Market Risk, it is a risk that affects the entire industry and not specific to a certain stock or market. This risk is unavoidable and mostly contingent in nature. Change in government policies and in economic situations on the international front and natural calamities are few examples.
- Unsystematic Risk – Also known as idiosyncratic risk, it is the risk pertaining to a particular market or industry or a stock. This can be managed through diversification, thereby minimizing the company’s exposure to that particular segment.
Consistent investment in diversified portfolios helps the investor prepare for the systematic risk or at least manage it well in the long run. High volatility & fear of risk often compels investors to choose as many as thirty to forty stocks in their portfolios.
Understanding Capital Asset Pricing Model
Capital asset pricing model (CAPM) is one such theory that helps in describing the relation between expected return from securities and the systematic risk involved. Based on the work of Harry Markowitz on diversification and modern portfolio theory, CAPM was developed by Jack Treynor, William.F.Sharpe, John Lintner and Jan Mossin independently around 1961-66. CAPM is used in finance industry for calculating the expected returns on an asset taking into account the cost of capital and the risk associated with them. Formula in CAPM for calculating expected return on asset is as follows:
ERi = Expected Return on Investment
Rf = Risk-free rate of interest
i = Coefficient of security
ERm = Expected return of the market
(ERm-Rf) = Market Premium
Beta (i) indicates the degree of risk involved in return on investment in correlation to the market situations. Beta for entire market is calculated as one by definition. A beta greater than one means the stock is more volatile and beta less than one means reduced volatility.
Rf, the risk free rate of interest denotes the time value of money. Interest on low risk government bonds can be considered as risk free interest.
(ERm–Rf) is the excess return from market over the risk free interest. This is the premium which compensates the risk that investor takes. Multiplying beta with market premium means the future cash flows of the asset are discounted in relation to its risk factor. If beta is higher, the stocks will be riskier and the discounting factor should also be higher and vice versa.
CAPM suggests that investors take only systematic risk and not diversifiable risk, as beta is the defining factor which rewards their risk exposure. Moreover systematic risk cannot be eliminated and can only be managed. To ensure creation of an optimal portfolio, investor has to add every single asset at its weighted value while calculating with this formula.
- Investors are price takers and cannot influence market price in any way.
- All investors aim at maximizing economic utilities of form, time, place and possession.
- Investors can access all the information at any time.
- Investors are rational in decision making and unwilling to take risk.
- Transaction cost and taxes are ignored.
- Risk and return are the only factors which influence investor’s investment choices.
- All investors operate in identical time zones i.e., they buy at the same time and sell at a common future point of time.
- Assets are marketable, divisible and available in same quantity for all investors.
- Unlimited borrowing or lending capacity at the risk free interest rate.
Problems with CAPM model
- Huge drawback of the model is to assume constancy of beta. Beta does not represent other essential variables that effect expected return like price-earnings ratio, debt-equity ratio and book to market ratio. It does not account for discounting systematic risk entirely as the risk is highly unpredictable and can change suddenly with any trigger.
- This model uses historical data to calculate the future return of an asset which may not give reliable results.
- Perfect capital market structure is a prerequisite for CAPM where all assets are valued correctly with availability of complete information. This may not be possible in real world where most of the decisions are company specific and the stock prices are highly biased.
- Investors do not get to borrow at all times for risk free interest rates
- Assumption that investors agree on taking the same amount of risk for same return on investment is a bit absurd.
- Estimating the value of equity risk premium is difficult.
Though CAPM faces criticism for its very defining factors, it has evolved to be a useful tool for financial advisors and investors to evaluate assets and create optimal portfolio. It helps in assessment of fair value of stocks and their premium for taking the risk of investing into it. The model isn’t perfect but it definitely answers some questions well. With the advent of behavioural economics, this model is all set to undergo transformation.