This video covers the concept behind the Capital Asset Pricing Model.
VIDEO SUMMARY
This video is on the Capital Asset Pricing Model. For short, people refer to this as the CAPM. I am going to start by putting up the equation. This is a mathematical equation. It was first published in the 1960s and the Nobel Prize in Economics was awarded in 1992 to William Sharpe, Harry Markowitz, and Merton Miller jointly for this work.
So what is the Capital Asset Pricing Model? It is a methodology to determine a rate for risk for a future cash flow. The CAPM is all about risk rates. I want to spend a little bit of time talking about how you should be thinking about rates and risk rates. It all follows a concept that goes “the higher the risk, the higher the return.” This is a common phrase in Finance. You might have heard of it. It seems simple, but it is really a pretty complex idea. What this describes is how people make financial decisions in the present moment. So in the present moment, you may be looking at a whole bunch of different investment decisions or business decisions. You are looking at all these different alternatives. The alternatives with higher levels of risk, you are going to be willing to pay less money for. What this means is that if you take one of those high levels of risk opportunities, you are going to pay less for it today so that in the future, if you realize those cash flows from that opportunity, you are going to be getting a higher level of reward. The opposite is true for opportunities that are lower levels of risk. You are going to be getting lower levels of reward. The confusing part about this idea, is that it is not a guarantee of future returns. This is where a lot of people sometimes go wrong. You can’t say that since “the higher the risk the higher the reward” that somehow implies you should go out and purchase high levels of risk to achieve high returns. It’s not a guarantee. We do not know what is going to happen in the future. All that it is guaranteeing is that you are holding high levels of risk today. You could have two opportunities, a low risk opportunity and a high risk opportunity. Either one of these could generate higher levels of return. We just don’t know. But what we are saying is that today in the present moment, you are going to be making a valuation decision, and that decision you are going to value that differently between the low level and high level of risk. Now it is also true that on a macro level, we do see this pattern play out across asset classes. So in general, for instance, we do see that stocks perform with the greater levels of return than bonds. Stocks are riskier than bonds, so people price stocks accordingly, and they end up generating higher levels of return for investors than bonds. This is what we would expect because people are making these rational decisions. But again, just as a warning, it is not a guarantee. There are years when the bond market performs better than the stock market. It just depends because there is a level of uncertainty there. That level of uncertainty is precisely why you price according to the level of risk.
So let’s walk through an example to illustrate this. Let’s say you are looking at two different opportunities. They are both going to take a hundred dollar investment. One opportunity is a ten percent investment or a ten percent risk. The other opportunity is a twenty percent risk. So this twenty percent risk, you are going to be expecting a higher payoff. So on the ten percent risk, for a hundred dollars you should be expecting to receive in the future 110. The twenty percent risk you should be expecting to receive 120. This is one of the central ideas of Finance. It is not good enough just to make money, you have to make enough money to compensate you for the level of risk that you hold. So for instance, this hundred dollar investment at twenty percent risk. If you made money but you only made 115, that is great that you made money, but you should have made 120 to compensate you for holding that risk. So even though you made money, in reality, you lost money because you should have made 120. There are all these asset classes out there, and different asset classes are at different levels of risk. So if you are playing in an investment space that is a low level of risk, it is okay if you make a low level of return. But if you are investing in an area of high risk, you should be making a high level of return. For instance, venture capitalists are investing in small startup companies. That is an area of high risk. They should be making a high level of return there. If they make a low level return, that is great that they made money, but they should have made a high level of return because they are holding a lot of risk.
In a practical sense, we are dealing with risk rates. If you have an opportunity with ten percent risk, your rate is going to be ten percent. What that means is that ten percent of the time, you are not going to get your money. That is a ten percent risk. That is how you get your rate. Usually rates exist on a spectrum between five percent and thirty percent. Now it could be a little bit lower or a little bit higher, but generally you are in that spectrum of five to thirty percent. Thirty percent is high and five percent is low. So the higher the risk the higher the rate. The lower the risk, the lower the rate. If you are getting into risks that are much more than thirty percent, it becomes questionable whether you should be making those business decisions because that is a high level of risk. If you are dealing with a 50/50 chance, then you might as well go to Vegas. So we are usually dealing in the range of five to thirty percent.
This all comes back to the present value equation. I made a couple videos on present value so I’m not going to go into it in detail. But I am going to put up the present value equation. Present value shows how we price things. So you are going to have some cash flow that you are going to expect in the future. What happens is you discount it by the risk rate. We are looking at this risk rate and for higher levels of risk, the risk rate is going to be greater. For lower levels of risk it will be lower. What that means is for higher levels of risk, you are going to discount your future cash flow for greater amounts. You are going to be willing to pay less for them today. This is how interest rates work. Let’s use the example of credit cards. If you have someone with poor credit, or high credit risk, they are going to have high interest rates. What is happening is the bank is discounting their future expected interest payments for a high level of risk. People who are low risk are going to have lower interest rates. All these concepts are really related on this overall concept of “the higher the risk, the higher the return.”
So to bring it back to the Capital Asset Pricing Model, the question here becomes, how do we calculate the risk rate? How do we actually get the number to plug into the equation? That is what the CAPM is for. In reality there are lots of different ways that you could go about getting a rate for risk. But the CAPM is a generally accepted approach in Finance for calculating rates and doing it in a consistent manner across your portfolio. So what I am going to do in the next video, we are going to walk through the capital asset pricing model. We will walk through the equation and talk about each of the variables.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.