We work in finance and we’ve achieved advanced degrees in finance. This doesn’t make us experts in finance, but it does give us the right to make some critical comments about an industry that revels in self-importance. Most of the people you encounter in finance would prefer that you think their work is far more complex than it actually is. It isn’t. If you edit genes, perform surgeries, design airplanes, or work on curing cancer, we’re impressed. If you memorized lots of worthless formulas and you can pontificate about things like the “capital asset pricing model (CAPM)”, we’re not so impressed.
Everyone in finance knows what CAPM is. It’s a common interview question and this is what it looks like:
Look at that drivel! Did you really need to use all those symbols to explain something so simple? Here’s what CAPM actually means.
Let’s say you’re a U.S. based investor with money to invest in the market. You could just put that money in government bonds and receive interest. We call that the “risk free rate” which is presently +.25% or 25 basis points. This is because aside from the U.S. defaulting on their debt, your investment is pretty much risk free.
What are basis points? Simply a way people in finance use to describe percentage points. 1% could also be referred to as 100 basis points. Feel free to really sound cool and use the term “bips”.
Now before we continue, we’re going to teach you what “beta” is. Beta is simply a measure of how volatile the daily returns of a stock are when compared to the daily returns of the market. That’s it. If a beta is 1, that means the stock is as volatile as the market. A beta of 2 means the asset is twice as volatile as the market. A beta of .5 means the asset is half as volatile as the market.
Now I hope you’re still following us because what we’ve explained so far is extremely sophisticated and if you don’t have a master’s in finance, you may be lost.
So we know that the risk free rate is the interest we receive in a savings account. We know that beta is how volatile a stock is. Now let’s take an index like the S&P500. That index has returned about +57% in the past 5 years. We can now use CAPM to tell us what return we expect from any given asset.
Let’s use McDonalds (MCD) as an example. MCD has a beta of .52. In order to calculate CAPM, we first need to the market returns over the past 5 years and subtract the risk free rate to get the “market premium”:
+57% minus +.25% = +56.75%
Why did we subtract the risk free rate? Because we could have made +.25% in a savings account and we only want to look at the actual returns the market is giving us.
Now, we multiple MCD’s beta of .52 times the market rate and get +29.51%. We then add back the risk free rate and we get +29.76%. CAPM tells us that we should expect returns from MCD of +29.76%. Over the past 5 years MCD returned +40.55% instead.
How lame is that? What exactly have we learned here by applying CRAPM? Pretty much nothing. What we can learn from this exercise though is that we can use beta as an indicator of how much we expect the price of a stock to fluctuate in good times or bad. Here are the betas for our Quantigence DGI Portfolio:
Since the beta of the market is 1, we see that our portfolio will on average be less volatile than the market. We can also see which assets are more likely to react should the market decide to crash on us. As for CAPM, we’ll leave that tool to the experts to use.