Understanding the CAPM and Return Expectations with Investments

Investing

 Plancorp Team By: Plancorp Team

Understanding market expected return and the Capital Asset Pricing Model (CAPM) for estimating returns is important for any investor.

This article provides an overview of how the CAPM helps determine expected stock market returns and how much the stock market has returned throughout its history per annum.

The Capital Asset Pricing Model and Market Return

The Capital Asset Pricing Model (CAPM) is a model used by financial analysts and investors to estimate expected returns on investments in security markets. Using the CAPM, given a security’s riskiness, an investor can estimate the expected return. 

This model is based on the premise that the only risk factor that investors consider when determining expected returns on a security is the measure of a security’s risk compared to the risk of the overall market.

Therefore, the expected return on any individual security can be expressed as the excess return of the overall market over the risk-free rate, also called the "market risk premium," multiplied by an additional term related to the risk associated with the security called the investment’s "beta." 

The result of this equation is then added to the risk-free rate to obtain the expected return of the security.

Expected Return Beta Relationship

A security with a beta of 1 has the same expected return as the overall market, whereas a stock with a beta of less than one is considered more conservative.

Its expected return and, thus, its risk is less than the market.

The CAPM Formula for Estimating Returns

The CAPM looks at the relationship between the risk-free rate, the expected market return, and the beta of the particular investment. The CAPM formula is expressed as: 

CAPM Formula

Expected return = risk-free rate + (expected market return - risk-free rate)  x  investment beta 

Market Risk Premium Formula

Market risk premium  = expected market return - risk-free rate

Expected Rate of Return Example and How To Calculate Market Return

A stock's expected rate of return is a critical metric for investors when evaluating potential investments.

Generally speaking, higher expected rates of return indicate higher risk, while lower expected rates of return indicate lower risk.

To illustrate the use of CAPM, consider a hypothetical stock ACME Corp. trading on the U.S. equity market with a beta of 1.2.

How to Find Expected Market Return

The market risk premium can be estimated by taking the risk-free rate (currently around 3.5% using the yield on the 10-year US Treasury Bond). The expected market return can be derived from historical data about stock market returns and, for this example, shall be set to 10%.

As a result, the market risk premium amounts to (10% - 3.5%) = 6.5%.

Multiplying the market risk premium with the stock's beta of 1.2  (6.5% * 1.2) = 7.8% and adding the risk-free rate of 3.5% results in a total expected return of 11.3% for ACME Corp.

ACME Corp., therefore, has a higher expected return of 11.3% than the market as a whole due to its above-average risk reflected in its beta of 1.2, which is bigger than 1.0.

It is important to point out that the CAPM does not predict returns of a single security but is a theoretical model to explain excess returns of risky assets when using only the risk-free rate and excess risk over market risk as factors.  

In addition, as the risk of a security can change over time, so can its expected rate of return because markets and other factors in the model are constantly changing.

What Is Market Return?

The Market return is the rate of return on an investment in a specific market or asset class. It typically refers to the overall performance of a market in the form of a stock index.

The market return would be the expected return of all risky securities if bundled into a single portfolio, like a broad market Index such as the S&P 500.

It is important to note that the broader and more diversified the observed portfolio, the better the estimate of the market return is. Using a portfolio of technology stocks, for example, or the Nasdaq 100, would not be an ideal measure of the market portfolio because it omits key sectors of the economy.

The expected market return is usually calculated as the weighted average of the returns on each asset in the portfolio. So, for example, if an investor wanted to look at the expected market return of the S&P 500, they would use the weighted return of the 500 stocks in the index.

The S&P 500 is a capitalization-weighted index, so it is ideally suited for measuring market return.

What Is the Average Stock Market Return? 

The return on investment in the stock market is far from a sure thing, as many factors can impact performance. However, investors can understand what to expect by looking at historical returns. According to historical stock market data, the average stock market return based on the S&P 500 Index since 1926 has been around 10% per year. 

This return can vary widely year by year and be heavily influenced by macroeconomic, political, and social trends. While an annual return of 10% can be a great encouragement for potential investors, it is important to note that stock market investing is a long-term game, and past performance does not guarantee future results. During market declines and crises, market returns have been negative for a prolonged period of time.

Additionally, returns on individual stocks can vary widely from the average and can be impacted by various factors, including company size, product mix, and sector.

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