Now that you have read about the CAPM, would you ever use it to make personal in
ID: 2742167 • Letter: N
Question
Now that you have read about the CAPM, would you ever use it to make personal investment decisions? How can an individual investor use or think about CAPM? Consider the following: WHAT IS THE MAIN MESSAGE OF THE CAPM? IT EVOLVES FROM THE NOTION THAT INVESTORS IN GENERAL AREN'T STUPID: THEY DIVERSIFY THEIR INVESTMENT FUNDS INTO A WELL DIVERSIFIED PORTFOLIO. MORE SPECIFICALLY - THE MAIN MESSAGE OF THE CAPM IS THAT THE RATE OF RETURN ONE SHOULD EXPECT TO EARN ON A PARTICULAR INVESTMENT IS ONLY RELATED TO THE SYSTEMATIC RISK OF THE SECURITY, NOT TO ITS TOTAL RISK. WHEN YOU PURCHASE A STOCK (BECAUSE YOU LIKE IT OR BECAUSE YOU GOT A 'TIP'), YOU'LL BE EXPOSED TO THE TOTAL RISK OF THIS STOCK, BUT THE MARKET THEORY IMPLIES THAT YOU'LL ONLY BE COMPENSATED FOR A SMALL PROPORTION OF THAT RISK. HENCE, IF YOU DO LIKE RISK YOU SHOULD INVEST IN A WELL DIVERSIFIED RISKY PORTFOLIO WITH MANY SECURITIES HAVING A HIGH BETA, RATHER IN AN INDIVIDUAL STOCK. NOW GO BACK TO THE INITIAL QUESTION AND PRESENT YOUR THOUGHTS... Do research on the Internet and show the reference for the information. Don't forget to respond to a colleague's posting also.
Explanation / Answer
Solution.
Your assumptions about the meaning of CAPM are false. The value of diversification that you mention falls out of Harry Markowitz's Modern Portfolio Theory, not from Bill Sharpe's CAPM.
Portfolio diversification is accepted by everyone as being a truly important factor in putting together a portfolio.
What CAPM says is that there is only one risk factor -- market risk, and that the reward for taking on more risk is linearly related to the amount of risk. There are two (and only two) conditions under which CAPM holds. The first is if the utility function of the investor is quadratic -- something that is certainly false.
The second condition under which CAPM holds is when the distribution of the returns of the market can be described in terms of mean and variance alone -- something like the Normal Distribution, the Lognormal Distribution or the Binomial Distribution. This is also, clearly, not the case. However, it does explain why CAPM is used for equities and not for other securities like Bonds or Options. The payoffs of those instruments are clearly skewed -- so CAPM doesn't work for them. But the returns for stocks have a hump shaped distribution that is close enough to normal/lognormal distributions that CAPM gives a reasonable approximations for short time horizons. It has been shown to be inadequate for longer time horizons.
Professional investors are more likely to use a model like APT (Arbitrage Pricing Theory) that is similar to CAPM, but allows more risk factors. APT will simplify to CAPM when there is only one risk factor.
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