Capital Asset Pricing Model
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In the investment world, many asset managers use a theory called Capital Asset Pricing Model (CAPM) to determine the correlation between the risk of investing in a particular asset and the predicted return on the investment. The overall theory behind the Capital Asset Pricing Model is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure that compares the returns of the asset to the market over a period of time and to the market premium.
Essentially, the Capital Asset Pricing Model says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment is not worthwhile and if correct, the investment should not be made.
Some investors argue that the Capital Asset Pricing Model is based on a number of assumptions that do not accurately represent the true nature of the investment. One example of this is that it is very difficult to find a risk free investment. A short term highly liquid government security is considered as a risk free security due to the fact that it is unlikely that the government will default, but inflation causes uncertainty about the actual rate of return from these securities. The assumption of the equality of the lending and borrowing rates is also believed to be incorrect because in reality these rates differ. Further investors may not hold highly diversified portfolios or the market indices may not well diversify. Under these circumstances capital asset pricing model may not accurately explain the investment behavior of investors and it may fail to capture the risk of investment.
Despite these arguments, thousands of investors both independent and institutional employ the capital asset pricing model for analysing their portfolio and identifying appropriate risk-return rations. These investors are able to select investments for their portfolio that have a specific return they are targeting, whilst ensuring they take on the minimum level of risk for this desired return. A lot of the investors who use the Capital Asset Pricing Model tend to prefer to invest in low-cost index funds and similar funds to invest over stocks. The difficulty with the strategy is that it is based on ever changing values/factors.
Essentially, the Capital Asset Pricing Model says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment is not worthwhile and if correct, the investment should not be made.
Some investors argue that the Capital Asset Pricing Model is based on a number of assumptions that do not accurately represent the true nature of the investment. One example of this is that it is very difficult to find a risk free investment. A short term highly liquid government security is considered as a risk free security due to the fact that it is unlikely that the government will default, but inflation causes uncertainty about the actual rate of return from these securities. The assumption of the equality of the lending and borrowing rates is also believed to be incorrect because in reality these rates differ. Further investors may not hold highly diversified portfolios or the market indices may not well diversify. Under these circumstances capital asset pricing model may not accurately explain the investment behavior of investors and it may fail to capture the risk of investment.
Despite these arguments, thousands of investors both independent and institutional employ the capital asset pricing model for analysing their portfolio and identifying appropriate risk-return rations. These investors are able to select investments for their portfolio that have a specific return they are targeting, whilst ensuring they take on the minimum level of risk for this desired return. A lot of the investors who use the Capital Asset Pricing Model tend to prefer to invest in low-cost index funds and similar funds to invest over stocks. The difficulty with the strategy is that it is based on ever changing values/factors.
