IFFM Blog #3: Modern Portfolio Theory and the Capital Asset Pricing Model

Modern Portfolio Theory (MPT) is an investing model where the investor tries to keep the market risk to the minimum in order to enjoy maximum returns for a given portfolio of investments. (Thune, 2017) It utilises mathematical tools assist investors to diversify, resulting in reduced risk.

Markowitz (1952) theorised two concepts of MPT, which are (D'Alessio, n.d.):

  1. Any investor's goal is to maxmise return for any level of risk
  2. Risk can be reduced by creating a diversified portfolio of unrelated assets
Markowitz (1952) also identified two further types of risks which could be affected by a strategy of investment diversification:
  1. Systematic Risk which affects all types of investments and impossible to diversify away
  2. Unsystematic (or Specific Risk) which can be diversified away


 Capital Asset Pricing Model (CAPM) is a stock valuation model that displays the correlation between expected returns and expected risks, where the return on an asset is equal to the risk-free return plus a risk premium, which is based on the stock's beta. (ft.com, nd.) The formula is presented in figure 1.
(Figure1. CAPM Calculation, themarketmogul.com)

A company uses debts and equities to finance its operations, obligations, and investments. Hence, CAPM measures the cost of capital on both the risk-free and high-risk component. It averages the risk portfolio into an index to indicate  (Watson and Head, 2010).

CAPM Strengths:

  • Ease of use, it is a simplistic calculation that can be used to derive multiple 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
  • CAPM takes into account systematic risk (beta), which is left out of other return models, such as the dividend discount model (DDM)
  • Unlike weighted average cost of capital (WACC), CAPM can be used if the business mix and financing differ from the current business


CAMP Weaknesses:

  • Risk-free Rate (Rf) being used as in input causes volatility as the yield changes daily
  • Return on the Market (Rm) causes an issue as at any given time, the market return can be negative
  • Ability to Borrow at a Risk-free Rate assumes that investors can borrow and lend at a risk-free rate, however, this is unattainable in reality.
  • Accurate determination of Project Proxy Beta is difficult and can affect the reliability of the outcome



References
Thune, K. (2017). How is Modern Portfolio Theory Used With Investing?. [online] The Balance. Available at: https://www.thebalance.com/what-is-mpt-2466539 [Accessed 30 Jan. 2018].

 D'Alessio, G. (n.d.). Markowitz’s Modern Portfolio Theory - What Is It & How It Works. [online] Ways2wealth.com. Available at: https://www.ways2wealth.com/investing/PostId/18/modern-portfolio-theory [Accessed 30 Jan. 2018].

 Lexicon.ft.com. (n.d.). Capital Asset Pricing Model Definition from Financial Times Lexicon. [online] Available at: http://lexicon.ft.com/Term?term=capital-asset-pricing-model [Accessed 30 Jan. 2018].

 Watson, D., & Head, A. (2010). Corporate finance: principles and practice. Pearson Education.

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