Investing in Portfolios and CAPM - Essay Example

Running Head: Investing in Portfolios Investing in Portfolios and CAPM Alternative Entire Investment in Evergreen Alternative 2: EntireInvestment in Ace Limited: Alternative 3: Invest half the funds in Evergreen and half the funds in ACE: Alternative 4: 90% Investment in Evergreen and 10% investment in ACE: j The above calculation sheds light on the fact that it is very important to invest in portfolios rather than taking exposure in one type of investment. Investing in portfolios has two advantages. First of all, it reduces the investor’s risk and secondly it improves the returns that the investor can earn. Therefore, many large investors and investment banks invest in portfolios or in a basket of investment rather than investing in one type of security or company. If the investor chooses alternative 1 and invests all the money in Evergreen, then he can earn a return of 13.8%. Since Evergreen is a safe company, therefore the standard deviation of returns is quite low and risk coefficient is only 0.11. One must keep in mind that by investing in this company, the investor is foregoing chance of earning high returns. In other words, the investor is foregoing chance of earning high returns for increased safety by investing in this company. On the other hand, in the case of alternative 2, if the investor decides to invest in more dynamic of the two companies ACE limited, then the investor is foregoing safety of investment for high returns. This will enable the investor to earn a return which is as high as 25%. However, the risk coefficient and standard deviation for this investment is also higher at 0.31 and 7.6% respectively. A third option is to invest in the form of an equally weighted portfolio. In this case, the returns have increased from what the investor could earn by investing solely in Evergreen and at the same time the high risk of investing in Ace Ltd has also been reduced. The returns have increased from 13.8% to 19% and at the same time risk coefficient has decreased from 0.31 to 0.2. In the case of alternative 4, the investor will invest heavily in Evergreen and take very small exposure in ACE. This option is probably the worst alternative because the returns of this option are not very high, but the risk has greatly increased to 0.47. In the above scenario, we can see that the returns have increased when the investor has decided to invest in portfolios and at the same time risk coefficient has gone down. This tells us that diversification leads to lower risk and high return. However, one must keep in mind that diversification only minimizes one type of risk that an investor faces. There is another kind of risk which is known as systematic risk and it cannot be eliminated no matter how well diversified the portfolio is. Hence, there is always some chance of investors losing money even if the money is invested in the form of a portfolio. The correlation coefficient above shows that the investment in Evergreen and Ace is negatively correlated. A shrewd investor always try to invest in companies that are negatively correlate so that the downward trend in the returns of one business can be offset by the increased returns on the other investment in the same portfolio. However, since these two investments are not perfectly correlated, the portfolio is not well balance and some side will be higher than another and investor can face periods of high returns or loss depending on the market situation. It can be concluded from studying the above alternatives that it is wise for investors to not to take large exposures on one single stock. The investors should try to construct portfolios that should give equal or close weightage to all the companies in the portfolios in order to enjoy the benefits of risk diversification. If there is one company in the portfolio which has higher weightage than the other companies ten the portfolio’s performance will be highly dependent on that one company and benefits of diversification will disappear. TASK 2: Capital Asset Pricing Model is a tool to calculate the required rate of return for a security. It takes into account the return that an investor can earn on risk free security (usually government T-Bills), risk premium (difference between the return on risk free investment and return on investment in market) and beta. Beta is a measure that is used to calculate the overall risk position of a company against the risk condition of the market. If the value of beta is greater than one, the stock is more risky as compared to the market. If the value of beta is less than one, then the stock is less risky as compared to the market. Capital Asset Pricing Model can be thought of as a system that takes the several market conditions as input and gives the rate of return than an investor should demand on a particular stock as an output. However, the modern financial gurus believe that the CAPM theory has become redundant and superfluous. Since the CAPM assumes that there are no other costs associated with the investment in a company, therefore the answer given by this model is of little use. However, there are several other reasons which have made this model redundant and these reasons are discussed in the next few paragraphs. (Fama and French, 2006 pp. 2163-2185) Some important concepts used in CAPM model are beta, risk free rate and risk premium. Beta encapsulates all the prevalent risks of the company. Beta is higher for aggressive companies and lower for matured companies. The reason behind high beta for aggressive companies is because they are risk investments. They have huge potentials to grow very rapidly. At the same time there are more chances for these companies to lose money and this is reflected in their correlation with the market. Hence, beta is an encapsulation of the risks that a business or a company can face. Another important concept of CAPM is the risk premium. Risk premium is the difference between the market risk and the risk faced by the safest investment. Investors with high risk appetite will go for companies with higher risk premiums because they can earn huge amount of return from investing in such companies and can build wealth very quickly. CAPM model also shows that the rate of return demanded by investors for risky investment is higher than safer investments. CAPM model is one of the most overused models of financial investments. Financial investors refer to this model whenever they are forced to make a decision involving financial investments. However, the model is redundant because of some of its superfluous assumptions that are not prevalent in the practical market space (Investopedia, 2012). The model is formulated on the assumption that there are no taxes or transaction costs for investors. In reality there are several transaction costs and taxes that an investor has to pay in order to execute the transaction. CAPM model fails to take into account such costs. Hence, the answer given by this model is far from being accurate and is always understated since many costs are ignored when calculating the cost of equity using this model. (Brigham and Erndhart, 2004 pp. 432-435) Another weakness of model lies in the fact that it fails to recognize the prevalence on non-diversifiable systematic risks in the markets. These risks are experienced by even the most generalized portfolios that reflect the market returns. Another thing that should be kept in mind here is the fact that there is no risk free investment in the market (McAdams and Kariagannis, 1994 pp. 57-60). All types of investments face certain types of risk no matter how safe they look. Even in the case of T-Bills and government securities, the reinvestment risk is always there and since it cannot be eliminated therefore there is no risk free investment. The model also assumes that the risk premium will be higher for stocks which have a beta of 2.0 and half for the stocks which have a beta of 0.5. This is no true in some cases. Risk premium does not only differ on the basis of risk profile of stock. Risk premium also differs because of the liquidity premium that is offered by some stock because they are very easy to buy and sell. Hence the CAPM model is weak in computing certain very important market assumptions and has become redundant because of its inability to take into account the important costs and assumptions that can shape an investment decision. (Forbes, 2012) The model also makes an assumption that all investors are risk averse and have same liquidity preference and time horizon. This is another set of superfluous or redundant assumptions. This is because all investors do not have same liquidity preference and time horizon. Not only this, but investors also differ in risk appetite. Some investors take large risks to make quick money. However, other investors try to play a safer game and try preventing losses and try to create assets and wealth gradually (Harris, 1980 pp. 99-122). There are also two different types of investors in the market. One types of investors try to invest in securities for the long-term, whereas the other set of investors are speculators and leave the market as soon as they earn their required amount of return. Since, CAPM model ignores all these important aspects of investing, the answer obtained from this model is not very accurate and pragmatic and hence one can say that the theory has become redundant over time. (Eun, 1994 pp.345-350) It can be concluded from the above discussion that Capital Asset Pricing Model or “CAPM” has become outdated because of its invalid nature and its inability to take into account the transaction costs and taxes that are prevalent in the system and distort the actual or real required rate of return demanded by an investor. The model also makes a false assumption that risk premium for stocks with a high beta will be higher than stocks and companies that have a lower beta. Beta is not the only factor in determining the risk premium. Certain stocks are being traded on discount because of the lack of liquidity that they offer to the investors. This thing is not built-in to the Capital Asset Pricing Model and hence the answer or result obtained from this model is superfluous or redundant in most cases and it is fair to say that this theory has become redundant over time as the sphere of financial knowledge has grown with the passage of time. References: Brigham, E. and Ernhardt, M. (2004) Fundamental of Financial Management. 4th ed. New York: South-Western Publisher, p.432-435. Eun, C. (1994) The Benchmark Beta, CAPM, and Pricing Anomalies. Oxford Economics Papers, 46 (2), p.345-350. Fama, E. and French, K. (2006) The Value Premium and the CAPM. The Journal of Finance, 61 (5), p.2163-2185. Forbes.com (2012) CAPM: The First Factor of Investing - Forbes. [online] Available at: http://www.forbes.com/sites/davidmarotta/2012/03/19/capm-the-first-factor-of-investing/ [Accessed: 19 Apr 2012]. Harris, R. (1980) A General Equilibrium Analysis of the Capital Asset Pricing Mode. Journal of Financial and Quantitative Analysis, 15 (1), p.99-122. Investopedia.com (2008) Measure Your Portfolios Performance. [online] Available at: http://www.investopedia.com/articles/08/performance-measure.asp#axzz1qQf7RXcW [Accessed: 28 Mar 2012]. Investopedia.com (1952) Capital Asset Pricing Model (CAPM) Definition | Investopedia. [online] Available at: http://www.investopedia.com/terms/c/capm.asp [Accessed: 19 Apr 2012]. Koster, J. (2010) Value Investing World: Another good debunking of the efficient market theory, CAPM, and the use of beta to measure risk. [online] Available at: http://www.valueinvestingworld.com/2010/04/another-good-debunking-of-efficient.html [Accessed: 19 Apr 2012]. McAdams, L. and Karagiannis, E. (1994) Using Yield Curve Shapes to Manage Bond Portfolios. CFA Institute, 50 (3), p.57-60. Read More