Capital market theory

Capital market theory refers to several types of analysis used to estimate the value of securities and to understand how supply and demand affect market prices. Three core ideas commonly grouped under capital market theory are:

• Capital asset pricing model
• Modern portfolio theory
• Efficient market hypothesis

Capital asset pricing model (CAPM)

The capital asset pricing model (CAPM) estimates a security’s expected return using only factors tied to systematic risk. CAPM uses the following formula (introduced earlier in a previous chapter):

$$\text{ER}=\text{RF + (Beta x (MR - RF))}$$

$$\begin{array}{rl}\text{Where:}& \\ ER& =\text{expected return}\\ RF& =\text{risk-free return}\\ MR& =\text{market return}\end{array}$$

Each input in the formula is market-based:

• The risk-free rate of return is typically the return on the 3-month (or 91 day) Treasury bill. Treasury bills aren’t literally risk-free, but they’re generally treated as having the lowest risk in the securities markets. In CAPM, this rate represents the return you’d expect with little-to-no systematic risk.
• Beta measures how volatile a security or portfolio has been relative to the overall market.
• The market return represents the return of the overall market (or a market benchmark), which CAPM uses as the reference point for systematic risk.

Let’s work through a typical CAPM question:

An investor is analyzing a large-cap stock fund prior to making a potential purchase. The expected return of the S&P 500 is 12%, while the security reflects a beta of 1.5 and a standard deviation of 22. Additionally, the 3-month T-bill rate is 2%. Assuming the investor is utilizing the capital asset pricing model, what is the expected return of the large-cap stock fund?

Notice what CAPM does not include: it doesn’t adjust for security-specific factors. Non-systematic risks such as business risk, financial risk, and liquidity risk aren’t part of the model. In other words, CAPM estimates expected return based on market dynamics and systematic risk only.

This formula may look familiar if you’ve worked with alpha. The connection is:

• CAPM calculates the expected return.
• Alpha compares actual return to that expected return (actual return minus expected return) to show whether performance was above or below what CAPM would predict.

Modern portfolio theory (MPT)

In 1952, economist Harry Markowitz published an essay on investing often viewed as the foundation of modern portfolio theory (MPT). The essay, titled Portfolio Selection, laid out principles for building an efficient portfolio. An efficient portfolio aims for the highest return potential while taking the lowest amount of risk necessary.

To develop these portfolio guidelines, Markowitz made several assumptions about investors, including:

• Investors share the same assumptions
• Investors can borrow at the risk-free rate
• Investors seek the highest return but are also risk averse

Given these assumptions, investors face a tradeoff: higher expected returns generally require taking on more risk. MPT addresses this tradeoff with a key tool: diversification.

An investor might pursue higher returns by holding a more volatile (riskier) security. MPT’s point is that you don’t have to evaluate that security in isolation. Risk in one holding can be offset by the behavior of other holdings. For example, losses in luxury cruise line stock during an economic downturn may be offset by returns in a defensive investment like pharmaceutical company stock.

When a portfolio is properly diversified, the risk/return profile of any one security becomes less important than the risk/return profile of the portfolio as a whole. This is why a conservative, risk-averse investor may still allocate a small portion of assets to a high-risk security while keeping the overall portfolio suitable.

One way to evaluate diversification is with the correlation coefficient, which measures how similarly two securities or portfolios have historically moved. Correlation ranges from -1 to +1:

• A correlation of +1 means the two investments move together at the same speed and in the same direction. For example, the S&P 500 index and an S&P index fund should maintain a correlation of 1. If the S&P 500 index is up 10% one day, the index fund tracking it should also be up about 10%.
• A correlation of -1 means the two investments move at the same speed but in opposite directions. For example, the S&P 500 index should maintain a -1 correlation with an inverse S&P 500 exchange-traded fund (ETF). If the S&P 500 index is up 10% one day, the inverse S&P 500 ETF should be down approximately 10%. Over longer periods, this correlation can decay because inverse ETFs reset their exposure daily.

All other correlations fall between -1 and +1:

• A correlation of 0 means there’s no relationship between the two investments.
• A correlation of 0.5 suggests they move in the same direction about 50% of the time.
• A correlation of -0.5 suggests they move in opposite directions about 50% of the time.

A common testable takeaway combines diversification and correlation: to further diversify a portfolio, you generally look for securities with negative correlations to the existing portfolio. Adding holdings that tend to move differently (or inversely) can help reduce losses when other parts of the portfolio decline.

Diversification across securities is only part of the picture. Asset allocation also matters. Strategic asset allocation builds on MPT by emphasizing a suitable long-term allocation, avoiding market timing, and periodically rebalancing. Used correctly, it helps keep the portfolio’s overall risk/return profile aligned with the investor’s objectives.