Introduction to Corporate Finance

7: Risk, Return and the Capital Asset Pricing Model

The seemingly random changes in share prices occur because prices respond only to new

information, and new information is almost by definition unpredictable. Numerous trading strategies

have been devised and tested in an attempt to earn above-average returns in the share market. Some

strategies suggest buying companies with the highest market share in their industry. Other strategies

propose buying shares of new companies with new technologies that could revolutionise an industry.

Still others suggest buying or selling shares based on patterns in share charts that allegedly repeat over

time.

Of course, there is no end to the number of trading strategies like these that can be tested using

the historical data. In the vast majority of cases, these trading strategies do not generate significantly

higher returns than a simple buy-and-hold approach. This suggests that share prices are indeed nearly

unpredictable.

The most compelling evidence that markets are efficient is a comparison of passively managed

versus actively managed mutual funds. A mutual fund that adopts a passive management style is called

an index fund. Index fund managers make no attempt to analyse shares to determine which ones will

perform well and which ones will do poorly. Instead, these managers try to mimic the performance of

a market index, such as the ASX 200, by buying the shares that make up the index. In contrast, fund

managers adopting an active management style do extensive analysis to identify mispriced shares.

Active managers trade more frequently than do passive managers, and in the process generate higher

expenses for their shareholders. Though there are notable exceptions (such as legendary managers

Peter Lynch, Warren Buffett and Bill Gross), most research indicates that active funds earn lower

returns (after expenses such as transaction costs and taxes) than passive funds are able to achieve.

Buy-and-hold wins again.

If this section concludes with the statement that share returns are essentially unpredictable, then it

is fair to ask why we place so much emphasis on the CAPM. After all, the CAPM’s purpose is to provide

an estimate of how a share will perform in the future. If share returns move essentially at random, then

does the CAPM have any place in the practice of corporate finance?

It is true that the CAPM provides only an estimate of a share’s expected return and that actual

outcomes deviate considerably (and unpredictably) from that estimate in any given year. Even so, the

CAPM gives analysts a tool for measuring the systematic risk of any particular asset. Because assets

with high systematic risk should, on average, earn a higher return than assets with low systematic risk,

the CAPM offers a framework for making educated guesses about the risk and return of investment

alternatives. Though it is hardly infallible, this framework enjoys widespread use in corporate finance, as

we will see in subsequent chapters.

9 If the share market is efficient, what makes it efficient?

10 If prices move almost at random, then why should we place any value on the CAPM, which makes

predictions about expected asset returns?

CONCEPT REVIEW QUESTIONS 7-4

See the concept explained

step by step on the

CourseMate website.

SMART

CONCEPTS

passively managed

A strategy in which an

investor makes no attempt

to identify overvalued or

undervalued shares, but

instead holds a diversified

portfolio

actively managed

A strategy in which an

investor does research

in an attempt to identify

undervalued and overvalued

shares

index fund

A passively managed fund

that tries to mimic the

performance of a market

index, such as the ASX 200