CAPM is one of the basic concepts that is important for investors to understand. History records that the CAPM was first introduced in 1964 by William Sharpe, a well-known economist who won the Nobel prize in economics. The CAPM was further developed by John Lintner in 1965 and Jack Treynor in 1969. Since then, the CAPM has become one of the most frequently used models in investment and risk management.
The purpose of using the CAPM is to assist investors in determining the expected return of an investment and also determining the risks associated with the investment. In its application, CAPM uses beta as a measure of the risk of an investment. Beta is a measure of the volatility of returns on an investment compared to the market as a whole.
In this article, we will discuss more about the basic concept of CAPM, implementation in investment, criticism of CAPM, and the importance of CAPM in investment. For that, let’s look at the description below.
Basic Concept of CAPM
Having understood the background to the development of the CAPM, it is time to learn the basic concepts associated with this model. The CAPM is based on several basic principles, one of which is that investors must take risk into account when making investment decisions.
The risk factor that is the main concern in the CAPM is systematic risk, namely the risk associated with the market as a whole. This risk cannot be avoided by investors, because it is influenced by economic and political conditions in the country. Therefore, investors must consider systematic risk in determining the expected return on an investment.
In CAPM, beta is one of the basic concepts that is important to understand. Beta is a measure of the risk of an investment compared to the market as a whole. If the beta of an investment is equal to 1, then the investment has the same risk as the market. If beta is greater than 1, then the investment has a higher risk than the market. Conversely, if beta is less than 1, then the investment has a lower risk than the market.
The expected return on an investment is calculated using the formula:
Expected Return = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate)
The formula above shows that the expected return of an investment depends on the risk-free rate (ie the interest rate received by investors without risk), the beta of the investment, and the market return (ie the return expected from the market as a whole).
By understanding this basic concept, investors can more accurately calculate the risk and expected return of an investment. This can help investors make wiser investment decisions and reduce the risk of unnecessary losses.
The steps that must be taken in using the CAPM include:
1. Determine the risk-free rate
The first step in using the CAPM is to determine the risk-free rate. This can be done by looking at the interest rates on government bonds that are considered risk free.
2. Calculate the beta
The second step is to calculate the beta of an investment. Beta can be calculated by comparing the volatility of return on investment with the volatility of return on the market as a whole.
3. Determine the market return
The next step is to determine the expected market return. This can be done by calculating the average return from the market in a certain period of time.
4. Calculate the expected return
By using the CAPM formula, the expected return of an investment can be calculated easily. By plugging in the risk-free rate, beta, and market return values into the formula, investors can determine the expected return of an investment.
Although CAPM can assist investors in determining the expected return and risk of an investment, there are some advantages and disadvantages that need to be considered in its use. The advantages of using CAPM include:
* Easy to use and apply in investment.
* Provide accurate information about the risk and expected return of an investment.
* Take into account the systematic risk factors associated with the market as a whole.
* This model is based on several assumptions that are not always in accordance with actual market conditions.
* Does not take into account the specific risk of an investment, such as business risk or financial risk.
* Does not consider non-financial factors that can affect the return on an investment, such as changes in regulations or social conditions.
In this case, investors should weigh the advantages and disadvantages of using the CAPM and choose the model that best suits their investment situation.
CAPM Usage Examples
After understanding the basic concept and implementation of CAPM, we can see an example of using this model in investing. One example of its use is in large technology companies such as Apple Inc.
As a large and stable technology company, Apple is considered to have low systematic risk. Therefore, Apple’s beta is estimated at around 1.2, which means that Apple’s investment risk is slightly higher than the market as a whole.
Using the CAPM formula, we can calculate the expected return on Apple’s investment. Let’s say the current risk-free rate is 3%, the market return is estimated to be around 8%, and Apple’s beta is around 1.2. So, the expected return from Apple’s investment can be calculated as follows:
Expected Return = 3% + 1.2 × (8% – 3%) = 9.6%
Thus, the expected return on Apple’s investment is around 9.6%.
However, it is important to remember that the CAPM only provides an overview of the risk and expected return of an investment. Investors should consider other factors such as the company’s financial condition and other non-financial factors before making an investment decision.
In addition, the use of CAPM can also be applied to other investments, such as stocks or investment portfolios. By understanding the basic concepts of CAPM and applying them appropriately, investors can make wiser investment decisions and reduce the risk of unnecessary losses.
In investing, understanding the risk and expected return of an investment is very important to minimize losses and maximize profits. CAPM, as one of the most commonly used investment models, can assist investors in determining the expected return and risk of an investment.
Although the CAPM has advantages in its use, this model also has disadvantages and assumptions that need to be considered. As investors, we must weigh the advantages and disadvantages of using the CAPM and choose the model that best suits our investment situation.
So, understanding and applying the CAPM concept in investing can help us make wiser investment decisions and reduce the risk of unnecessary losses. However, we must always remember that making investment decisions must consider other factors such as the company’s financial condition and other non-financial factors. Thus, our investments can run better and provide the expected results.