Capital market theory makes reference to multiple forms of analysis that aim to predict the value of securities and the flow of supply and demand in the market. In this section, we’ll discuss a model, theory, and hypothesis, all of which are considered integral components of capital market theory. They are:
The capital asset pricing model (CAPM) predicts a security’s expected return based solely on factors related to systematic risk. CAPM utilizes the following formula, which we loosely discussed in a previous chapter:
The three components of the formula - risk-free return, beta, and market return - all relate to a security or portfolio’s systematic risk. The risk-free rate of return refers to the rate of return on the 3-month (or 91 day) Treasury bill. While technically not free of all risk, Treasury bills are considered to have the lowest level of risk in the securities markets, and therefore provide insight into the returns that can be expected with little-to-no systematic risk. Beta refers to a security or portfolio’s volatility as compared to the general market. The market return provides insights into expected volatility in the market.
Let’s take a look at an example of a 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?
Can you figure it out?
Answer = 17%
Let’s first determine the necessary components of the expected return formula:
Now, let’s establish the expected return formula:
The standard deviation is not necessary to perform this calculation.
All components of the expected return formula relate to the market, and have little to do with the actual security itself. Non-systematic risks like business risk, financial risk, and liquidity risk are not factored into this model. Bottom line - the calculation above only determines expected return based on market dynamics and risks.
If the expected return formula above seems similar, it is. When you learned how to calculate alpha, we utilized all the components of this formula. The only difference between the two is the alpha calculation involves subtracting the expected return (what we’re calculating above) from the actual return of the security or portfolio. CAPM only determines the expected return, while alpha compares that expected return to the actual return to determine if the portfolio or security is over or underperforming expectations.
In 1952, economist Harry Markowitz published an essay on investing that still remains relevant in the financial industry today and is often referred to as the birth of modern portfolio theory (MPT). Aptly named ‘Portfolio Selection,’ this essay established a number of rules and protocols for attaining an efficient portfolio. The most efficient portfolio is one with the highest return potential for the lowest risk exposure.
In order to set forth protocols for creating an efficient portfolio, Markowitz made several assumptions about investors, including:
With those assumptions in place, investors face a catch-22. They want the highest possible returns, but also don’t want to expose themselves to risk. They want to avoid risk, but would not be content with obtaining a risk-free rate of return. As we’ve established throughout this material, with more risk potential comes more return potential. So, how does MPT recommend investors deal with this conundrum? One key component is diversification.
An investor may seek high returns with a highly volatile (risky) security. While a fair amount of risk may be present with any given investment, it can be balanced out with the potential returns of other securities. For example, a loss experienced on luxury cruise line stock due to an economic downturn may be offset by the returns on a defensive investment like pharmaceutical company stock.
When a portfolio is properly diversified, the risk/return profile of any one given security is not important. Instead, the risk/return profile of the overall portfolio should be the primary focus. This means a conservative, risk-averse investor may allocate a small portion of their assets to a high-risk security and still maintain a suitable portfolio.
An investor can utilize the correlation coefficient to determine the best security to add to a portfolio for further diversification. Correlation references the similarities in the market price fluctuations of two different securities or portfolios. It is measured on a scale of negative 1 to positive 1. Two securities or portfolios with a perfect correlation of 1 have market prices that have historically moved at the same speed and in the same direction. For example, the S&P 500 index and an S&P index fund should have maintain a correlation of 1. If the S&P 500 index is up 10% one day, then the index fund tracking its performance should also maintain a 10% return. The two have a perfect correlation.
On the other side, a security with a perfect negative correlation (-1) moves 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%. The two have a perfect negative correlation day-to-day. However, the correlation will decay in the long run due to the investors’ holdings effectively being adjusted daily.
All other correlations will fall between -1 and 1. A correlation of zero means there’s no relationship between the two securities or portfolios being compared. A correlation of 0.5 roughly translates to the two comparisons acting similarly 50% of the time. A correlation of -0.5 roughly translates to the two comparisons acting as inverses 50% of the time. And so forth.
A key test point integrates diversification and correlation. If an investor wants to further diversify their portfolio, they should invest in securities with negative correlations to the portfolio. By doing so, they’re introducing new components that act inversely to the rest of the investor’s securities (on average). When the overall portfolio is losing value, the new securities with negative correlations should increase in value, thereby reducing the investor’s losses.
Beyond diversifying a portfolio across a number of different securities, proper asset allocation also plays an important role. Strategic asset allocation builds upon the principles of MPT by encouraging the maintenance of a suitable long-term asset allocation, avoiding market timing, and periodically rebalancing. When implemented correctly, an investor can ensure their portfolio retains an appropriate risk/return profile.
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