Welcome to Finance and Fury. How useful is investment theory when it comes to practically investing and calculating an expected return?

Lot of theory when it comes to investing – efficient frontiers, EMH – working out expected returns

In this episode – we will look at One aspect – CAPM – and look at Beta – see how well this can be used when selecting investing –

What Is the Capital Asset Pricing Model?

- The Capital Asset Pricing Model (CAPM) describes the relationship between the risk (volatility) of the market and expected returnfor an investment – used in the share market mainly –
- Foundation for theory that is used throughout finance for pricing securitiesthat have risk – volatility –

- The formula – calculating the expected return is as follows:
- Expected return = RF + BETA X Risk Premium
- Risk free rate of return – Investors expect to be compensated for risk and the time value of money. The risk-free rate in the CAPM formula accounts for the time value of money.
- 10-year bond is normally the risk-free rate

- The other components of the CAPM formula look at the incentives for an investor taking on additional risk
- This is due to investments beta is then multiplied by the market risk premium
- Risk Premium = Expected return of market – RF
- the return expected from the market above the risk-free rate
- gives an investor the required return or discount rate they can use to find the value of an asset.

- But the big one is the Beta – The beta of a potential investment is a measure of how much risk the investment has when compared to the market –
- The aim of Beta is a measure of the volatility of a security or portfolio compared to the market as a whole and is meant to show if the investment has a chance to provide above market returns
- The value of Beta effectively describes the activity of a security’s returns as it responds to swings in the market.
- If a share is riskier than the market, it will have a beta greater than one. If a stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio – can be positive or negative
- Beta Value Equal to 1.0 – indicates that its price activity is strongly correlated with the market – could either be the index or a fund/investment that acts exactly like it – active fund that is a benchmark hugger –

- Beta Value Less Than One – theoretically less volatile than the market – seen as less risky than high betas

- Beta Value Greater Than One – indicates that the investments price is theoretically more volatile than the market – for example – if a shares beta is 1.5 – assumed to be 50% more volatile than the market – indicates that adding this investment to a portfolio will increase the risk, but may also increase its expected return
- Can also have Negative Beta Value – Some stocks have negative betas. A beta of -1.0 means that the stock is inversely correlated to the market benchmark – inverse ETFsare designed to have negative betas – not great to have two assets with negative betas –

- Examples – RF 2%, market return is 8% – CAPM relies on assumptions – come back to this
- Beta of 1 = ER= 2%+1x(8%-2%) = 8%
- Beta Greater than 1 – 3 = ER= 2%+3x(8%-2%) = 20%
- Beta less than 1 – 0.5 = ER= 2%+0.5x(8%-2%) = 5%
- Beta of -1 = -4% p.a. ER

- RF asset is low at the moment – long term – say it was 5% – how does this change
- Beta of 1 = ER= 5%+1x(8%-5%) = 8%
- Beta Greater than 1 – 3 = ER= 5%+3x(8%-5%) = 14%
- Beta less than 1 – 0.5 = ER= 5%+0.5x(8%-5%) = 6.5%
- Beta of -1 = 2% p.a. ER

- As the RF asset increases – the beta starts to become less important –
- But Theory that over the long term – additional beta means more growth – Is it true?

Beta in Theory vs. Beta in Practice

- In theory – beta assumes that a shares returns are normally distributed from a statistical perspective – average returns over time – but financial markets are prone to large surprises – like what has just occurred – the returns have outliers – not normally distributed – so the ER relying on Beta doesn’t have a short term (or LT) ability to predict the expected return
- How well does this stack up in practice – Look at BETA of a few managed funds – and returns
- Four funds to look at – compare Betas, the calculated ER, the actual 10y return

Beta |
2.02 |
0.95 |
0.86 |
1 |

ER |
14.120% |
7.700% |
7.160% |
8.000% |

AR-10y |
6.69% |
6.84% |
7.75% |
5.66% |

Difference |
-7.4300% |
-0.8600% |
0.5900% |
-2.3400% |

- Large Cap – benchmark unaware
- Large cap – geared – Beta of 2.02

- Large Cap – active growth – 0.95

- Index – 1

- Compare long term returns – the differences are not what is expected based on theory – but make sense –

- How – betas less than 1 have less of a systematic risk – this is the Beta value of 1 in a way – the risk of the entire market declining – when the whole index collapses -this is an example of a systematic-risk event – the Systematic risk of the index by itself is un-diversifiable risk –
- If it is your only investment – it means your funds will lose value – but a beta of less than 1 means it is less volatile than the market – but it may be get a better long term return if it goes stable consistent upwards returns that compound over time

- Why Beta isnt the best way to think about risk – or expected returns –
- Also on the other side – an investment with a very low beta could have smaller price swings, but these may be in a long-term downtrend – so it looks like it is less risky – but locking in a long term loss
- Similarly, a high beta stock that is volatile in a mostly upward direction will increase the risk of a portfolio, but it may add gains as well. It’s recommended that investors using beta to evaluate a stock also evaluate it from other perspectives—such as fundamental or technical factors—before assuming it will add or remove risk from a portfolio.

- Another major problem of Beta – calculated using historical data points, it becomes less meaningful for investors looking to predict a future movements in prices – i.e. the expected return is relying on historical volatility –
- These data points become less useful for long-term investments – most risk measures like Beta are tracked over a 3 or 5 year timeframe – volatility can change significantly from year to year
- Also – volatility is a measure or price movements – but the price movements in both directions are not equally risky – or as good for your investment returns – i.e. volatility of 10% p.a. may either be up or down – Beta doesn’t track this
- The look-back period to determine a stock’s volatility is not standard because stock returns (and risk) are not normally distributed

Due to the problems of Beta – there are Problems With the CAPM

- Beyond Beta – the assumptions behind the CAPM formula have been shown to not work out in reality – most of modern financial theory rests on two major assumptions:
- First – markets are efficient – that is, relevant information about the companies is quickly and universally distributed and absorbed – there is no overbuying or overselling in markets – the market acts efficiently and the price of the market reflects the information that is available
- Second – these markets are dominated by rational, risk-averse investors, who seek to maximize their returns on their investments – therefore no buying high or selling low should occur – but emotions overrise the rational side of investors

- Other assumptions – that the risk-free rate and the expected return
- Risk free rate – assumed that it will remain constant over the long term –
- When this is used in getting the FV through discounting for cashflow – if the RF rate increases – it will increase the capital costs and make companies look overvalued – also the reverse is true – when it goes down – discounting for CF can make assets look undervalued – and good buys with higher Betas – which can be a massive trap

- Expected returns – The market portfolio that is used to find the market risk premium is only a theoretical value – it relies on assumptions – most of the time the index average returns is used – over a 10 or so year period as well – so the ASX200s return as a benchmark would be used for CAPM in Aus to substitute for the market – but this is an imperfect science as an be expected

- Risk free rate – assumed that it will remain constant over the long term –
- Regardless of these issues – the CAPM formula is still widely used because it is simple and allows for easy comparisons of investment alternatives – but markets are not simple – so watch out for relying on this if you are getting into investing

Summary – theory can help – but in understanding – practical use – limited – so when it comes to using these theories if you are getting into personal investments – it can be used in conjunction with other metrics when building a portfolio

- It is useful to understand how beta works – and how the expected returns

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