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Priniciples of Finance: Capital Asset Pricing Model (CAPM)

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Please research Capital Asset Pricing Model (CAPM), and would you ever use it to make personal investment decisions?

Consider the following:

WHAT IS THE MAIN MESSAGE OF THE CAPM? IT EVOLVES FROM THE NOTION THAT INVESTORS IN GENERAL AREN'T STUPID: THEY DIVERSIFY THEIR INVESTMENT FUNDS INTO A WELL DIVERSIFIED PORTFOLIO. THEREFORE IF ALL ARE WISE ENOUGH, IT FOLLOWS THAT THE 'MARKET' WON'T COMPENSATE PEOPLE FOR NOT BEING SMART ENOUGH TO DIVERSIFY. MORE SPECIFICALLY - THE MAIN MESSAGE OF THE CAPM IS THAT THE RATE OF RETURN ONE SHOULD EXPECT TO EARN ON A PARTICULAR INVESTMENT IS ONLY RELATED TO THE SYSTEMATIC RISK OF THE SECURITY, NOT TO ITS TOTAL RISK. WHEN YOU PURCHASE A STOCK (BECAUSE YOU LIKE IT OR BECAUSE YOU GOT A 'TIP'), YOU'LL BE EXPOSED TO THE TOTAL RISK OF THIS STOCK, BUT THE MARKET THEORY IMPLIES THAT YOU'LL ONLY BE COMPENSATED FOR A SMALL PROPORTION OF THAT RISK. HENCE, IF YOU DO LIKE RISK YOU SHOULD INVEST IN A WELL DIVERSIFIES RISKY PORTFOLIO WITH MANY SECURITIES HAVING A HIGH BETA, RATHER IN AN INDIVIDUAL STOCK.

NOW GO BACK TO THE INITIAL QUESTION AND PRESENT YOUR THOUGHTS...

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Solution Preview

As we know that the Capital Asset Pricing Model (CAPM) is used to identify the minimum return an investor must expect from a particular stock. There are two types of risk: systematic and unsystematic risk. Systematic ...

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