Capital Asset Pricing Model – How To Know Risky Security

The Markowitz technique gave a method of figuring out how risky each security is, relative to another individual security, but it did not give a calibration for the risk of each security vis-à-vis a standard benchmark of risk. Beginning in 1966, Sharpe and three other writers put forward methods that calibrate how risky an individual security is. They distinguished two types of risk: a type that can be eliminated by diversification, like the vulnerability to fluctuations in the price of oil in our earlier example, and risk that cannot be eliminated by diversification. They called these two types of risk unsystematic and systematic, or diversifiable and undiversifiable. The model they put forward is called the Capital Asset Pricing Model. Its key parameter is the measure of risk of an individual security, and they used the Greek letter beta to represent that.

The Capital Asset Pricing Model was a breakthrough because it simplified Markowitz’s method. After it came out, more portfolio managers could apply scientific portfolio selection criteria. It helped in two other ways that were equally important. It allowed independent observers to calibrate whether one portfolio manager was taking more risk than another. In the past, there had been star managers who took big risks and sometimes made big returns for their clients. The Capital Asset Pricing Model allowed observers to tell whether these star managers had achieved their superior performance by selecting mostly risky stocks or by selecting safer stocks. Managers who take bigger risks sometimes do well, but are more likely to have periods of very bad performance. The other way it helped was to give analysts a formula that could predict the effect on a company’s stock price if it acquired another company, sold off a division, issued bonds and then bought back its common stock, or took any other major step.

This breakthrough accelerated several trends in portfolio management and corporate financial management. It gave the scientific portfolio managers another advantage over the old portfolio managers who relied on rules of thumb. It broke the remaining ties of loyalty that were still remaining between stockholders and corporate treasurers. Professional portfolio managers attracted more money, and individual investors handed over more and more of their assets to professionals and paid them to manage the assets. Corporate treasurers learned quickly that they had to offer securities with attractive features, or they would have difficulty placing the securities. Buyers were experts, and they eyeballed each new issue critically before deciding whether to buy any of it. There were no longer as many gullible buyers, no captive buyers, and no buyers who would subscribe to a new issue for reasons of loyalty. The new formula made it too easy to compute the correct price of the security, and if the company tried to get a price higher than that, the buyers would shun the issue.

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