How useful is investment theory when it comes to practically investing and calculating an expected return?

Welcome to Finance and Fury. How useful is investment theory when it comes to practically investing and calculating an expected return?

Lot of theory when it comes to investing – efficient frontiers, EMH – working out expected returns

In this episode – we will look at One aspect – CAPM – and look at Beta – see how well this can be used when selecting investing -

What Is the Capital Asset Pricing Model?

The Capital Asset Pricing Model (CAPM) describes the relationship between the risk (volatility) of the market and expected returnfor an investment – used in the share market mainly – Foundation for theory that is used throughout finance for pricing securitiesthat have risk – volatility –   The formula - calculating the expected return is as follows: Expected return = RF + BETA X Risk Premium Risk free rate of return - Investors expect to be compensated for risk and the time value of money. The risk-free rate in the CAPM formula accounts for the time value of money. 10-year bond is normally the risk-free rate The other components of the CAPM formula look at the incentives for an investor taking on additional risk This is due to investments beta is then multiplied by the market risk premium Risk Premium = Expected return of market – RF the return expected from the market above the risk-free rate gives an investor the required return or discount rate they can use to find the value of an asset. But the big one is the Beta - The beta of a potential investment is a measure of how much risk the investment has when compared to the market – The aim of Beta is a measure of the volatility of a security or portfolio compared to the market as a whole and is meant to show if the investment has a chance to provide above market returns The value of Beta effectively describes the activity of a security's returns as it responds to swings in the market. If a share is riskier than the market, it will have a beta greater than one. If a stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio – can be positive or negative Beta Value Equal to 1.0 - indicates that its price activity is strongly correlated with the market – could either be the index or a fund/investment that acts exactly like it – active fund that is a benchmark hugger - Beta Value Less Than One - theoretically less volatile than the market – seen as less risky than high betas Beta Value Greater Than One - indicates that the investments price is theoretically more volatile than the market – for example – if a shares beta is 1.5 - assumed to be 50% more volatile than the market - indicates that adding this investment to a portfolio will increase the risk, but may also increase its expected return Can also have Negative Beta Value - Some stocks have negative betas. A beta of -1.0 means that the stock is inversely correlated to the market benchmark - inverse ETFsare designed to have negative betas – not great to have two assets with negative betas – Examples – RF 2%, market return is 8% - CAPM relies on assumptions – come back to this Beta of 1 = ER= 2%+1x(8%-2%) = 8% Beta Greater than 1 – 3 = ER= 2%+3x(8%-2%) = 20% Beta less than 1 – 0.5 = ER= 2%+0.5x(8%-2%) = 5% Beta of -1 = -4% p.a. ER RF asset is low at the moment – long term – say it was 5% - how does this change Beta of 1 = ER= 5%+1x(8%-5%) = 8% Beta Greater than 1 – 3 = ER= 5%+3x(8%-5%) = 14% Beta less than 1 – 0.5 = ER= 5%+0.5x(8%-5%) = 6.5% Beta of -1 = 2% p.a. ER As the RF asset increases – the beta starts to become less important – But Theory that over the long term – additional beta means more growth - Is it true?

Beta in Theory vs. Beta in Practice

In theory - beta assumes that a shares returns are normally distributed from a statistical perspective – average returns over time – but financial markets are prone to large surprises – like what has just occurred – the returns have outliers – not normally distributed – so the ER relying on Beta doesn’t have a short term (or LT) ability to predict the expected return How well does this stack up in practice - Look at BETA of a few managed funds – and returns Four funds to look at – compare Betas, the calculated ER, the actual 10y return

Beta

2.02

0.95

0.86

1

ER

14.120%

7.700%

7.160%

8.000%

AR-10y

6.69%

6.84%

7.75%

5.66%

Difference

-7.4300%

-0.8600%

0.5900%

-2.3400%

Large Cap – benchmark unaware Large cap – geared – Beta of 2.02 Large Cap – active growth – 0.95 Index – 1 Compare long term returns – the differences are not what is expected based on theory – but make sense - How – betas less than 1 have less of a systematic risk – this is the Beta value of 1 in a way - the risk of the entire market declining – when the whole index collapses -this is an example of a systematic-risk event - the Systematic risk of the index by itself is un-diversifiable risk – If it is your only investment – it means your funds will lose value – but a beta of less than 1 means it is less volatile than the market – but it may be get a better long term return if it goes stable consistent upwards returns that compound over time Why Beta isnt the best way to think about risk – or expected returns – Also on the other side – an investment with a very low beta could have smaller price swings, but these may be in a long-term downtrend – so it looks like it is less risky – but locking in a long term loss Similarly, a high beta stock that is volatile in a mostly upward direction will increase the risk of a portfolio, but it may add gains as well. It's recommended that investors using beta to evaluate a stock also evaluate it from other perspectives—such as fundamental or technical factors—before assuming it will add or remove risk from a portfolio. Another major problem of Beta - calculated using historical data points, it becomes less meaningful for investors looking to predict a future movements in prices – i.e. the expected return is relying on historical volatility – These data points become less useful for long-term investments – most risk measures like Beta are tracked over a 3 or 5 year timeframe - volatility can change significantly from year to year Also – volatility is a measure or price movements – but the price movements in both directions are not equally risky – or as good for your investment returns – i.e. volatility of 10% p.a. may either be up or down – Beta doesn’t track this The look-back period to determine a stock’s volatility is not standard because stock returns (and risk) are not normally distributed

Due to the problems of Beta – there are Problems With the CAPM

Beyond Beta - the assumptions behind the CAPM formula have been shown to not work out in reality – most of modern financial theory rests on two major assumptions: First – markets are efficient - that is, relevant information about the companies is quickly and universally distributed and absorbed – there is no overbuying or overselling in markets – the market acts efficiently and the price of the market reflects the information that is available Second - these markets are dominated by rational, risk-averse investors, who seek to maximize their returns on their investments – therefore no buying high or selling low should occur – but emotions overrise the rational side of investors Other assumptions - that the risk-free rate and the expected return Risk free rate – assumed that it will remain constant over the long term – When this is used in getting the FV through discounting for cashflow – if the RF rate increases – it will increase the capital costs and make companies look overvalued – also the reverse is true – when it goes down – discounting for CF can make assets look undervalued – and good buys with higher Betas – which can be a massive trap Expected returns - The market portfolio that is used to find the market risk premium is only a theoretical value - it relies on assumptions – most of the time the index average returns is used – over a 10 or so year period as well – so the ASX200s return as a benchmark would be used for CAPM in Aus to substitute for the market – but this is an imperfect science as an be expected Regardless of these issues - the CAPM formula is still widely used because it is simple and allows for easy comparisons of investment alternatives – but markets are not simple – so watch out for relying on this if you are getting into investing

Summary – theory can help – but in understanding – practical use – limited – so when it comes to using these theories if you are getting into personal investments – it can be used in conjunction with other metrics when building a portfolio

It is useful to understand how beta works – and how the expected returns

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