CAPM - Stock Investing Tool or Not?
Now that you know how to use the CAPM for stock investing matters it’s time to be more critical in terms of how useful the CAPM is for practical applications.
First of all, let’s have a closer look at the assumptions that the CAPM sets:
1. Investors behave rational and risk-averse.
2. Everybody has perfect information ( = everyone is like an insider!)
3. Borrowing or lending is always possible at the riskfree interest rate
4. No transaction costs.
Now decide for yourself. Do you really think that investors always behave rational and risk-averse? Think about booming and crashing days, this is probably not the case.
What about perfect information? Yeah, that would be really great, isn’t it? To know everything about every company, that would give you a clear advantage for your stock investing! No, it wouldn’t, because the assumption is that everybody knows it :)
As you can see, the assumptions are really unrealistic, but nevertheless shall we use it for stock investing decisions?
Well, a bigger problem is this:
The CAPM uses the risk factor “beta”. Do you know where this info comes from? It comes from historical data. And these are assumed to continue in the future. But risk factors can change anytime. Moreover, the market return is also just expected, not guaranteed!
The security line of the CAPM tries to explain return subject to the risk it carries.
So, the more risk you take on, the more return you can expect. Well, if stock investing would be so easy…
But this risk-return-relationship is not always linear, it’s much more complex. Another problem is that a stock’s expected return is solely dependent on the market return. We all know that there are much more influencing factors for a stock’s price than only its portfolio.
A bunch of other problems exist with this methodology, but I think it’s enough to know that for stock investing purposes this model is a bit too simplified. In spite of this, I would recommend you to explore this for yourself. The more you explore the more you discover!
Stock Investing
First of all, let’s have a closer look at the assumptions that the CAPM sets:
1. Investors behave rational and risk-averse.
2. Everybody has perfect information ( = everyone is like an insider!)
3. Borrowing or lending is always possible at the riskfree interest rate
4. No transaction costs.
Now decide for yourself. Do you really think that investors always behave rational and risk-averse? Think about booming and crashing days, this is probably not the case.
What about perfect information? Yeah, that would be really great, isn’t it? To know everything about every company, that would give you a clear advantage for your stock investing! No, it wouldn’t, because the assumption is that everybody knows it :)
As you can see, the assumptions are really unrealistic, but nevertheless shall we use it for stock investing decisions?
Well, a bigger problem is this:
The CAPM uses the risk factor “beta”. Do you know where this info comes from? It comes from historical data. And these are assumed to continue in the future. But risk factors can change anytime. Moreover, the market return is also just expected, not guaranteed!
The security line of the CAPM tries to explain return subject to the risk it carries.
So, the more risk you take on, the more return you can expect. Well, if stock investing would be so easy…
But this risk-return-relationship is not always linear, it’s much more complex. Another problem is that a stock’s expected return is solely dependent on the market return. We all know that there are much more influencing factors for a stock’s price than only its portfolio.
A bunch of other problems exist with this methodology, but I think it’s enough to know that for stock investing purposes this model is a bit too simplified. In spite of this, I would recommend you to explore this for yourself. The more you explore the more you discover!
Stock Investing
posted by jophan at
3:13 PM
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