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You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy. A new paper argues that factor investing challenges the year-old Capital Asset Pricing Model CAPM developed by William Sharpe, which asserts that only way to outperform the market is by holding stocks with higher systemic risk. Many studies have shown that factors beat plain vanilla market capitalization-weighted benchmarks and funds across most global markets, according to the paper.
They also apply to other asset classes, such as fixed income, and even commodities to some extent, added Hunstad. Factors, of course, have drawbacks. One company manufactures suntan lotion. Its stock predictably performs well in sunny years and poorly in rainy ones. The other company produces disposable umbrellas. Its stock performs equally poorly in sunny years and well in rainy ones.
In purchasing either stock, investors incur a great amount of risk because of variability in the stock price driven by fluctuations in weather conditions. Unfortunately, the perfect negative relationship between the returns on these two stocks is very rare in the real world. To some extent, corporate securities move together, so complete elimination of risk through simple portfolio diversification is impossible.
However, as long as some lack of parallelism in the returns of securities exists, diversification will always reduce risk. On the other hand, because stock prices and returns move to some extent in tandem, even investors holding widely diversified portfolios are exposed to the risk inherent in the overall performance of the stock market.
Examples of systematic and unsystematic risk factors appear in Exhibit I. Exhibit II graphically illustrates the reduction of risk as securities are added to a portfolio. Empirical studies have demonstrated that unsystematic risk can be virtually eliminated in portfolios of 30 to 40 randomly selected stocks. Of course, if investments are made in closely related industries, more securities are required to eradicate unsystematic risk.
Exhibit II Reduction of unsystematic risk through diversification. The investors inhabiting this hypothetical world are assumed to be risk averse. This notion, which agrees for once with the world most of us know, implies that investors demand compensation for taking on risk.
In financial markets dominated by risk-averse investors, higher-risk securities are priced to yield higher expected returns than lower-risk securities. A simple equation expresses the resulting positive relationship between risk and return. The expected return on a risky security, R s , can be thought of as the risk-free rate, R f , plus a premium for risk:.
These assumptions and the risk-reducing efficacy of diversification lead to an idealized financial market in which, to minimize risk, CAPM investors hold highly diversified portfolios that are sensitive only to market-related risk. Since investors can eliminate company-specific risk simply by properly diversifying portfolios, they are not compensated for bearing unsystematic risk.
Thus an investor is rewarded with higher expected returns for bearing only market-related risk. This important result may seem inconsistent with empirical evidence that, despite low-cost diversification vehicles such as mutual funds, most investors do not hold adequately diversified portfolios.
These actively trading investors determine securities prices and expected returns. If their portfolios are well diversified, their actions may result in market pricing consistent with the CAPM prediction that only systematic risk matters. Beta is the standard CAPM measure of systematic risk. It gauges the tendency of the return of a security to move in parallel with the return of the stock market as a whole.
A stock with a beta of 1. Stocks with a beta greater than 1. Conversely, a stock with a beta less than 1. Securities are priced such that:. I have illustrated it graphically in Exhibit III. As I indicated before, the expected return on a security generally equals the risk-free rate plus a risk premium. In CAPM the risk premium is measured as beta times the expected return on the market minus the risk-free rate.
The risk premium of a security is a function of the risk premium on the market, R m — R f , and varies directly with the level of beta. No measure of unsystematic risk appears in the risk premium, of course, for in the world of CAPM diversification has eliminated it. In the freely competitive financial markets described by CAPM, no security can sell for long at prices low enough to yield more than its appropriate return on the SML.
The security would then be very attractive compared with other securities of similar risk, and investors would bid its price up until its expected return fell to the appropriate position on the SML. Conversely, investors would sell off any stock selling at a price high enough to put its expected return below its appropriate position. An arbitrage pricing adjustment mechanism alone may be sufficient to justify the SML relationship with less restrictive assumptions than the traditional CAPM.
One perhaps counterintuitive aspect of CAPM involves a stock exhibiting great total risk but very little systematic risk. An example might be a company in the very chancy business of exploring for precious metals. Viewed in isolation the company would appear very risky, but most of its total risk is unsystematic and can be diversified away.
The well-diversified CAPM investor would view the stock as a low-risk security. In practice, such counterintuitive examples are rare; most companies with high total risk also have high betas and vice versa.
Systematic risk as measured by beta usually coincides with intuitive judgments of risk for particular stocks. There is no total risk equivalent to the SML, however, for pricing securities and determining expected returns in financial markets where investors are free to diversify their holdings.
Let me summarize the conceptual components of CAPM. According to the model, financial markets care only about systematic risk and price securities such that expected returns lie along the security market line. Select personalised content.
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Select personalised ads. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. The widely used capital asset pricing model CAPM —when put into practice—has both pros and cons. The capital asset pricing model CAPM is a finance theory that establishes a linear relationship between the required return on an investment and risk.
The model is based on the relationship between an asset's beta , the risk-free rate typically the Treasury bill rate , and the equity risk premium, or the expected return on the market minus the risk-free rate. At the heart of the model are its underlying assumptions, which many criticize as being unrealistic and which might provide the basis for some of its major drawbacks. No model is perfect, but each should have a few characteristics that make it useful and applicable.
There are numerous advantages to the application of the CAPM, including:. The CAPM is a simple calculation that can be easily stress-tested to derive a range of possible outcomes to provide confidence around the required rates of return. The assumption that investors hold a diversified portfolio, similar to the market portfolio, eliminates unsystematic specific risk.
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