240 Part 3 Financial Assets
8-3 RISK IN A PORTFOLIO CONTEXT: THE CAPM
In this section, we discuss the risk of stocks when they are held in portfolios rather
than as stand-alone assets. Our discussion is based on an extremely important the-
ory, the Capital Asset Pricing Model, or CAPM, that was developed in the 1960s.^15
We do not attempt to cover the CAPM in detail—rather, we simply use its intuition
to explain how risk should be considered in a world where stocks and other assets
are held in portfolios. If you go on to take a course in investments, you will cover
the CAPM in detail.
Thus far in the chapter we have considered the riskiness of assets when they
are held in isolation. This is generally appropriate for small businesses, many real
estate investments, and capital budgeting projects. However, the risk of a stock
held in a portfolio is typically lower than the stock’s risk when it is held alone.
Since investors dislike risk and since risk can be reduced by holding portfolios,
most stocks are held in portfolios. Banks, pension funds, insurance companies,
mutual funds, and other " nancial institutions are required by law to hold diversi-
" ed portfolios. Most individual investors—at least those whose security holdings
constitute a signi" cant part of their total wealth—also hold portfolios. Therefore,
the fact that one particular stock’s price goes up or down is not important—what is
important is the return on the portfolio and the portfolio’s risk. Logically, then, the risk and
return of an individual stock should be analyzed in terms of how the security affects the risk
and return of the portfolio in which it is held.
To illustrate, Pay Up Inc. is a collection agency that operates nationwide through
37 of" ces. The company is not well known, its stock is not very liquid, and its earn-
ings have experienced sharp! uctuations in the past. This suggests that Pay Up is
risky and that its required rate of return, r, should be relatively high. However, Pay
Up’s required return in 2008 (and all other years) was quite low in comparison to
most other companies. This indicates that investors think Pay Up is a low-risk com-
pany in spite of its uncertain pro" ts. This counterintuitive! nding has to do with diversi-
! cation and its effect on risk. Pay Up’s earnings rise during recessions, whereas most
other companies’ earnings decline when the economy slumps. Thus, Pay Up’s stock
is like insurance—it pays off when other things go bad—so adding Pay Up to a port-
folio of “regular” stocks stabilizes the portfolio’s returns and makes it less risky.Capital Asset Pricing
Model (CAPM)
A model based on the
proposition that any
stock’s required rate of
return is equal to the risk-
free rate of return plus a
risk premium that reflects
only the risk remaining
after diversification.Capital Asset Pricing
Model (CAPM)
A model based on the
proposition that any
stock’s required rate of
return is equal to the risk-
free rate of return plus a
risk premium that reflects
only the risk remaining
after diversification.(^15) The CAPM was originated by Professor William F. Sharpe in his article “Capital Asset Prices: A Theory of Market
Equilibrium Under Conditions of Risk,” Journal of Finance, 1964. Literally thousands of articles exploring various
aspects of the CAPM have been published subsequently, and it is very widely used in investment analysis.
SEL
F^ TEST What does investment risk mean?
Set up an illustrative probability distribution table for an investment with
probabilities for di" erent conditions, returns under those conditions, and the
expected return.
Which of the two stocks graphed in Figure 8-3 is less risky? Why?
Explain why you agree or disagree with this statement: Most investors are
risk-averse.
How does risk aversion a" ect rates of return?
An investment has a 50% chance of producing a 20% return, a 25% chance of
producing an 8% return, and a 25% chance of producing a !12% return.
What is its expected return? (9%)