Good to see you here again!
If you listen to our last episode about IRR, this new episode will teach you about CAPM which can help you with finance, business, and investment.
If you haven’t heard our last episode title “What is IRR?”
Check it out, because there’s a lot of lessons that you can learn in that episode.
In this episode, you will…
- Listen about what is CAPM?
- Learn about CAPM Formula
- Why should we use CAPM? What is it for?
- How can we apply it in Real states?
- Helps you determine about good investments or not?
- Learn about market risk
Resources Mentioned In This Episode:
Hello, my friends and welcome back to another episode of the freedom formula for physicians podcast, a podcast dedicated to helping doctors like you slash your debt, slash your taxes, and live a liberated lifestyle. Well, today we are continuing this series of trying to teach you kind of the basic finance of understanding terms that I learned in business school that maybe you are not familiar with. And certainly if you’ve taken business classes in finance, specifically, you have heard of some of these concepts. But if you haven’t, perhaps you have not heard some of these concepts.
So today, we are going to ask the question, what is CAPM, C-A-P-M, it’s the capital asset pricing model. Capital asset pricing model is basically trying to assess risk versus reward. And you can use CAPM for paper assets, you can use cap them for real estate, you know, there’s all kinds of ways that you can measure it, CAPM is a very specific formula. So very specific formula. But it’s pretty easy to understand this is not complicated.
Here’s the formula, the risk-free rate plus beta, we’ll talk about beta here in a moment. And we’re multiplying beta times the expected rate of return minus the risk-free rate. So imagine, the right side of the equation is beta times expected rate of return minus risk-free rate, the left side of the equation being just risk-free rate. So we have to add up and multiply that right side of the equation before we can add the risk-free rate to it. So I hope that makes sense to you.
Investopedia has great information, I’m sure Wikipedia and all kinds of other places do too. So what is behind, this formula, what was behind the CAPM, and why we want to use it is because we want to evaluate the reasonableness of future expectations as to whether or not an investment might be a good one. We have this whole thing we grapple with, with so many different investment possibilities, we have to weigh the risk and reward of each one of them. And so there’s this whole idea that markets are efficient. How can I explain that essentially, things are priced accurately. So that’s one of the assumptions behind capital asset pricing model, that as you’re taking more risk, that you should expect a higher and higher rate of return as your risk increases.
So in this formula, where we have the risk-free rate, plus beta times your expected rate of return minus the risk-free rate, let’s break down each one of these components. And that’s equal to CAPM, which is the expected return of the investment. So the risk-free rate, most people will measure the risk-free rate as being something that is extremely low on the risk scale. So for example, if you have a savings account or a money market account or something, something like that, you know, on a scale of one to 10, that’s a one, you know, very, very, very low risk there. There’s government insurance behind some of that stuff. So you could use a savings account or a money market rate or something like that as a risk-free rate of return.
A lot of people will generally look at treasury bonds as an example, as being a benchmark of a risk-free rate. So something that may That’d be the United States government might be another country that man, they have a sterling reputation, great cash flows, we know that they’re going to pay, therefore it’s risk-free, a risk-free rate. So typically, people might plug in 2% or 3%, somewhere in that range based on maybe a 10 year Treasury, or something like that as a benchmark.
So let’s use 3% as an example. But you could use 2%. Because 1%, we can argue what that risk-free rate of return should be. So that’s the first thing we add on the left side of the equation. Now we’re going to use that same number on the right side of the equation for the risk-free rate as well, because we’re going to subtract that, from our expected rate of return for an investment. The next number that we should probably talk about is the expected rate of return. And this is where there’s, there’s a lot of conjecture, and it can be hard to measure this because now you got to plug in an assumption. First, we assumed the risk-free rate. Now we got to plug in an assumption of what that expected rate of return might be.
So let’s say, for real estate, for example, that we feel that 6% is a good solid historical rate of return, this investment might do better, I might do worse, but we feel an average this kind of investment might be a 6% rate of return. So now, let’s use 6% minus the 3%. That gives us three, right? On the right side of the equation. Well, now we have the multiply that times the beta, what is beta is how does this potential investment measure up to how much risk this particular investment will compare to a larger portfolio of them like the whole market. So if we buy a million-dollar house, compared to a $200,000, starter home, there is a lot more risk in that million-dollar home compared to the average value, let’s say is $200,000 and most houses, so your beta might be a two, twice as much risk versus the general market. So if we take that two, now that risk that we’re taking, we’re measuring the amount of risk that we’re taking two times that difference, 6% minus 3%, that gives us 6%. Again, right, six minus three is equal to three, three times two, our beta gives us six. And now we have to add that to our risk-free rate 6% plus 3%, gives us nine 9%. Being the overall expected rate of return on this investment, which actually, I’m sorry, the expected rate of return in that formula is the expected rate of return for the market in general. So if the market is six for let’s just say houses, then we subtract the three. And that gives us 3% is the expected return on the market now we’re multiplying times beta for this specific investment. So the 9% total expected rate of return for the investment is like you’re getting another 3% on top of the market at six. So it’s telling us the expected rate of return for investment relative to the market relative to the risk-free rate. So essentially, as we compare for an efficient market, we should expect the more risk you’re taking that beta number, the higher your rate of return, the lower the risk, the closer to the risk-free rate you get the lower your rate of return is going to be and again this is all assuming an efficient market well we all know sometimes things go crazy sometimes or not in an efficient And market at all, you know, you can take a look at March of last year during the pandemic. And in certain assets got creamed. Every asset got creamed for a brief time period doesn’t matter what it was a paper asset, or real estate, or whatever, things got creamed for a short period of time.
So there’s a lot to absorb here. A lot of assumptions that we make in terms of what they are. And ultimately, you know, what, what this should help you with is determining whether or not it’s worth the risk to invest in an asset.
Last week, we talked about the internal rate of return, which is another way of measuring it, CAPM is helping us analyze, what’s the market at what is the risk of this investment relative to other ones cuz remember, IRR wasn’t telling us relative risk, CAPM now we bring that in. Now we can talk about relative risk on top of an IRR. So we can look at those things together. And we can run multiple scenarios in IRR. Look at CAPM could look at multiple scenarios and CAPM to determine does this looks like a good investment or not? So that’s ultimately what we’re trying to do, as we look at different degrees of risk different kinds of investments, and trying to figure out what is this all about.
So that basically is a very quick primer, my friends on this concept. I hope now if you ever hear it, you know you can talk about it somewhat intelligently. I made a mistake when I talked about the initially I forgot to mention that it was the market risk of that category, not that specific investment. So I make mistakes to myself, as I get passionate and talking about this. There’s remember this term CAPM as a way of measuring risk relative to the risk-free rate relative to that same category of investments. And remember, all of this is based on assumptions and what your assumptions aren’t. So the main lesson I can tell you from practical experience is using a variety of assumptions is the right way to go. And so my friends that wraps up another episode for today, I would love to hear from you on what are other finance topics. And as I look forward to the rest of this season, at season seven coming next year, I would love to know from you what are topics that we should tackle What are basic finance terms that you’re like, what the heck is that? And what does that mean? I would love to hear from you to have a good idea of how I can better serve you in these podcast episodes. As you know doctors mean so much to me and my family want to do my part to contribute back to you guys and helping you understand everything here for the freedom formula for physicians podcast.
This is Dave Denniston, thank you again so much for listening, my friends, wish you and yours all the best. And remember, to slash your debt, slash your taxes and live a liberated lifestyle.