All investments are faced with risks. While these risks could be minimized through diversification of portfolios, it is not possible for an investor to fully eliminate them. So, it’s true to say that even investment portfolios are faced with risk, only that it’s on a minimal level. Thus at any given time investors take up some risk and a rate of return is deserved as a compensation for risk taking. The Capital Asset Pricing Model (CAPM) is one of the commonly used model in the estimation of investment risks and their expected return. Investor are rational, they would not take up much risk if what they expected as the return for such an undertaking is not significant. When the compensation (in terms of returns) expected by the investor for a certain undertaking is high, the investor wouldn’t mind risking their investment. Similarly, if the expected return is low, investors will be observed to completely avoid the investment. Therefore, investors are more attracted to the expected returns irrespective of the risks involved. The CAPM is a financial too used in the measurement of strategic risks. Mullins (1982) stated that it is important for a financial manager to measure the cost of capital for a company. However, this is a difficult task that created a need for the use of the CAPM to reach at such an estimate. The role of this model is to provide methodology for risk quantification and translation of this risk in the estimation of the expected equity returns. According to Mullins, the model yields an estimated cost or equity that is objective in nature making this a principle advantage for investors.
According to McClure (2017), it was William Sharpe a financial economist who gave birth to this model in his book “Portfolio Theory and Capital Markets”, dated 1970. In his formulation of this model, he noted down an idea that there are two types of risk that faces individual investments; the systematic and unsystematic risks. In the definition of systematic risks, he noted down that these type of risks could not be eliminated by diversification as they faced the entire market (Ku?Rschner, 2008). He gave examples of inflation, recession, wars and interest rates.
Fig: Systematic and Unsystematic risks
Source: Mullins (1982)
For the Unsystematic risks, he noted that these risks could be minimized through portfolio diversification; the risks are said to be faced by individual stocks and that investors decisions can influence them.
Fig: Level of Reduction of risks through diversification
Source: Mullins (1982)
Diversification has been proved even by the modern portfolio theory as a strategy for unsystematic risk elimination only. This is confirmed in the graph above provided by Mullins. However, the concern of CAPM is on the systematic risks that face investments. Its aim at ensuring that investors are able to quantify these risk and hence be able to determine the appropriate returns on the investment. McClure noted that Sharpe’s argument was for the equality of the return on individual or portfolio of stocks and the cost of capital. Throughout finance, risky securities are priced using this model and thus it’s an important model. The introducers of the model stated that the return expect should be equal to the market risk plus an addition risk premium. The following formula was developed for CAPM;
ER = rf + βa(rm – rf)
Where,
Rf = the risk free rate
βa = Security’s beta
rm = Market return
(rm – rf) = The risk premium.
The risk premium is the compensation demand by the equity investors for accepting some extra risk. It is determined by subtracting the risk free rate from the whole markets’ expected return (Focardi and Fabozzi, 2004). Sharpe noted that it is then multiplied by a coefficient (beta). Beta measures the relevant volatility of stocks and is thus the only relative measure for the riskiness of stocks. It shows the magnitude of the changes in prices of stocks given the upward or downward movement of market stock. The beta of a share price is one if there is an equivalent movement between the share price and the stock market. I.e. if the stock market’s price change is by 10 %, the share price also changes by 10 %. If the beta of a stock is more than one, it means that a change in the stock market for instance by 10 % will result to a more than 10 % change in the share price. I.e. a beta of 1.2 would indicate that, a change is stock market by 10 % will result in the share price changing by 12 %. The stock portfolio’s financial returns and their betas are noted to portray a linear relationship.
Fig: Market returns against the stock’s beta
The compensation required by the equity investors for the acceptance of additional risk is obtained by multiplying the risk premium by the stock’s beta. Let’s assume that a stock has a beta of 1.5, a 3 % risk free rate and a 7 % market rate of return. In this case, the risk premium is (7 % – 3 % = 4 %). 4 % is the excess market return. Multiplying the excess market return by the stock’s beta we get the stock’s excess return = 1.5 * 4 = 6 %. The expected return = (the risk free rate + the stock’s excess return) = (3 % + 6 %) = 9 %. This confirms that for a risky investment, investors require a risk premium above the risk free rate. CAPM dominates the modern financial theory although sometime it is criticized on being developed based on assumptions that are unrealistic.
There are two assumptions in which the modern financial theories are based upon; the first one is that there is competition and efficiency in the securities market such that, all information about a company that is relevant to an investor is distributed quickly and universally and is absorbed. For this case, the financial markets are assumed to be populated by buyers and sellers who are highly sophisticated and well-informed. The second assumption is that investor are rational and risk averse. There are argued to maximize their utilities from their investment returns. Investors prefer more to less as they care more on wealth. In modern financial theory, hypothetical investors demand a higher expected return as premium for assuming higher risks. The two assumptions are the major basis in which the modern financial theory are formulated. However, CAPM development involve other limiting assumptions that are more specialized. For instance, the assumption that there is absent of imperfections such as taxes, transactional costs, borrowing and short selling restrictions. Investors are assumed to operate in a common horizon such that they agree on the securities’ risks and the likely performance.
The Assumptions of CAPM are that; the same interest rate can be used by investors in borrowing and lending, there is a risk-free rate; efficient portfolios are created by investors as they are all rational in their decisions; all investors’ expectations for investment are identical and that they expect the same future cash. The main CAPM implications as a result of the above assumptions are that of; (i) a mean-variance efficient market Portfolio; (ii) average return being an increasing function of beta
It is a general asset pricing theory which suggests that there are many macroeconomic factors that determines the financial assets’ expected returns (Wilkinson, 2013). The difference between this theory and CAPM is that CAPM relies of a single factor in the determination of the expected returns while APM is based on a multiple factors. This makes APM to be considered more realistic since in the real world there are many factors which influence the price of stocks. The macroeconomic variables may include; inflation, unemployment, economic output, savings or investment considerations. A change in any of such factors results in a change in the value of the asset. However, the challenge posed by this model is that of identifying the various factors that could influence the value of the given asset; this is a difficult task for the investors. They are however forced to identify these factors. Arbitrage means taking advantage of the market where the prices are higher.
The formula for calculating the returns on a security (r) through the APM model is given by;
r = E (r) + B1F1 + B2F2 + …………+ BnFn + e
Where,
E (r) is the security’s expected return
B1 is the sensitivity of the security to first factor’s movements
F1 is the First Factor
Bn is the sensitivity of the security to last factor’s movements
Fn is the last factor
e is the security’s return idiosyncratic component
The theory is based on the assumption that in the market there exist some mispriced assets. Investors are mostly interested in identifying the underpriced assets so as to make good profits from them. Wilkinson noted some three assumptions of the APT; (i) the relationship between a security’s risk and returns can be described by using a factor model; (ii) ability to diversify away the idiosyncratic risk; (iii) absence of persisting arbitrage opportunities.
Though the study on finance has been done for so many years, the behavioral finance is a new area that considers the behavior of human in finance. Sewell (2007) gave the definition of behavior finance as the study of how financial practitioners are affected influenced by psychology and how this in turn impacts the market. It is a combination of financial and psychological factors explaining the operations of the market, where some investors display complications and human limitations. There are theories of behavior finance based on psychology. They try to explain how cognitive errors and emotions impact the behavior of individual investors (Forrester, 2014; Ackert and Deaves, 2009). They also noted that, in traditional finance, investors were taken to make individual rational decisions (Chandra and Kumar, 2008). Rationality means that the consider risks and returns in their decision making. However, in the modern period there is a probability that the individual investors may deviate from traditional models. To be specific, (Shleifer, 2000) noted that it is persistent and therefore predictable.
The behavioral finance aspects compliments the traditional assumption of rationality. This paper will consider various behavior finance influential factors. Empirical evidence has shown that under given conditions of risk, the decisions of individual investors are motivated by many factors that are explained under behavior finance.
According to Alquraan, Alqisie and Shorafa (2016), there is an assumption in the traditional financial theory that investors are rational when seeking to maximize their wealth. However, when it comes to investment decisions, their ingrained thought patterns, emotional inclinations and psychological biases may affect their rationality. According to Rabin (1996), psychology explores in a systematic way the human behavior, judgement and well-being. This results in an explanation of the differences that exist between human beings. The role of behavior finance according to Ricciardi and Simon (200a) is to improve an understanding of the investors’ reasoning patterns, the involved behavioral factors and the magnitude of their influence on the decision making process.
The factors categorized under behavioral biases will be observed to be overlapping or indistinguishable. Even with the correct information, the presence of behavioral biases results in investors arriving at wrong conclusions since the biases limits and distorts information (Spaulding, 2017). The descriptions and explanations of how share prices are driven by emotions and biases are provided in behavior finance (Sewell, 2005).
Intelligence in decision making is often overruled by emotions and facts may be filtered. Investors give much weigh on agreeable facts but tend to ignore or underweight antithetical facts to one’s predisposition. Investors tend to avoid regrets “regrets avoidance”; thus they only carry out transactions there are assured of gaining or rather not losing. For instance, an investor may hold a losing position for long waiting for them to be profitable or rather would sell a winning position too soon with an idea to lock profits before they turn into losses (Pompian, 2006).
Higher portfolio turnovers may result from over confidence in one’s abilities which subsequently results in lower returns. Over an extended time, professional portfolio managers and some few investors may beat the market but this does not eliminate the presence of a significant proportion of active portfolio management. According to Strong (2006), overconfidence results in exaggeration of the investor’s ability in controlling event thus causing them to underestimate the risk at hand. Men are known to have more confidence than women and thus they trade more actively (Tekçe and Y?lmaz, 2015). They end up making lower returns from their active trading whereas women make greater returns.
New information may dictate an action or rather a change in one’s strategy. Thus, some investors hesitate to act immediately on such information. This hesitation results in different investors’ action at different time frames. This ends up causing a momentum as the point of reaction for more investors to the dispersed information is arrived at.
Some investors are consistent with using one strategy even if the strategy is sub-optimal and failing to avoid contradict one’s decisions through new information.
This is the possibility of an investor avoiding a certain investment even if there is a higher probability of gaining. This is what we explained with holding for long loosing positions to avoid making losses. These investors has a greater marginal utility for capital at hand and therefore put more value on it than that prospected to be gained. For instance, if an investment opportunity is such that there is a 50 % chance of earning $ 20,000 from a $ 50,000 investment and an equivalent chances of loss, most investors would avoid this investment. According to Forgel and Berry (2006), sometimes individual investors make mistakes in their evaluation and decision making. When they realize this and are faced with a stock selling option, they fall in a situation where their initial purchase price emotionally affect them. This limits the dependability of the decisions they make.
These are based on the fact that there are some things not known to some investors.
Investors perceive risk differently. They thus make their decisions based on the magnitude of the perceived risks they faced or may be faced with (Ricciardi, 2004).
When market recovers, investors get optimistic. But when it falls into a recession they become extremely pessimistic. Reliance on recent events on decision making rather than considering historical events causes an over/ under reaction of the market by investors, causing a bad news to result in a great price fall, or a good news to a higher price rise (Kengatharan and Kengatharan, 2014). Past losers become underpriced whereas past winners become overpriced (Shefrin, 1999).
Source: (Kitces, 2014)
Whereas the active management is manager-based, the passive management is index-based. Although beta is not used in predicting how a particular movement may affect an individual stock, it is used by investors in safely deducing that high-beta stocks portfolio moves more than the changes in the market in either direction and that the low-beta stock portfolio moves less than the changes in the market in either direction. Beta is important to investors (especially fund managers) as they hold money based on their expectation of market movement. For instance if the market is expected to fall, the decision made by investors is to hold low-beta stocks. Similarly, when the markets is expected to go up, investor’s decision is to hold high-beta stocks (in excess of 1). This decision making is based on tailoring the investors’ portfolios to their specific requirements for risk-returns. Securities are ranked based on their deviation from beta (Draper, 2016). Smart Beta helps in factor diversification.
Conclusion
In the comparison of the two models, it can be concluded that CAPM is based on a single factor, whereas APM is a multifactor model. There can be a set up for the APM to consider many risk factors, such as inflation rates, the business cycle, interest rates, and energy prices. There is the differentiation between systematic risk and unsystematic risk by the APM, and then the incorporation of these risk into the model; this is done for each given factor. The APM formula includes each factor Variable, and a factor beta for each. Because the APM includes many factors it can be considered superior to the CAPM.
The efficient market hypothesis fails to explain some market anomalies and activities which creates a rationale or the introduction of behavior finance. There are many behavioral factors that have been published on an argument to impact the market. These are the psychological factors taken advantage by the Contrarian and momentum strategies. The behavioral finance aspects have a great impact of distorting the process of decision making. The beta of a security is important to investors. A high beta in required when prices are going up, but when the prices are falling, a low beta is preferred.
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