Capital Asset Pricing Model Investing Strategy

Do you know how much risk you are taking when investing in an instrument? Do you know whether the instrument is rightly priced? Or do you know whether you are getting sufficient return for the risk you are taking? One investing model can give you answers to all these questions; and the model is known as Capital Asset Pricing Model or CAPM.

Capital asset pricing model is a simple to understand and follow strategy that tell you about the risk and return associate with an instrument, market or portfolio. It also tells you about whether the instrument is over-priced or under-priced. CAPM thus help investors to make sound investment decisions especially in screening the instruments which offer sufficient return for the risk taken.

The mathematical formula for capital asset pricing model is

Return (R) = Rf + beta x (Rm - Rf)

Where, Rf is the rate of risk-free investments or the time value of money or it is the money you can grow without taking any risks. Beta is the beta value associated with the instrument/market/portfolio or is the risk of loss associated with your investments. Rm is the expected market return. Investments are good if the expected return from the investment equals/exceeds required return.

Example, if the risk-free rate ratio is 5%, the beta value of a stock (or other instrument) is 4% and expected market return is 8%, then the expected return (R) according to CAPM is 5 + 4 (8 - 5) = 17%.

Investors can also draw a Security Market Line (SML) for graphical representation of CAPM. It is a straight sloppy line (resembling ‘/ ’) giving the relationship of risk and return. X-axis is the risk or beta and Y-axis is the expected market return. If the expected return from the investment is above SML, then the investment are considered undervalued and is expected to offer good return for risk taken. If the expected return is below SML, then the investment is overvalued and is predicted to offer lesser return against risk taken.

Investors across the globe use capital asset pricing model for optimizing their portfolio for suitable risk-return levels. One can optimize his/her portfolio for a specific return while taking minimum risks for that return. Many investors who follow CAPM prefer low-cost index funds and similar funds to invest over stocks. The difficulty with the strategy is that it is based on ever changing values/factors.