 Are you ready for a graduate level discussion on investing, and how to build a portfolio? We promise to keep the jargon to a minimum, and to explain academic terms, if we can’t avoid using them.

At Springwater, our approach to building investment portfolios for our clients is based on decades of academic research. That research explains how securities like stocks (and bonds, and mutual funds) are priced. It also provides a blueprint for how to build portfolios with the best risk and return characteristics.

Let’s first consider securities pricing.

The Capital Asset Pricing Model (CAPM) tells us that investors expect a return on their money for investing it, and for accepting the risk of the loss of their investment. There is a fancy mathematical formula which explains this relationship.

The CAPM formula tells us that your reward for the use of your money (i.e. investing it rather than spending it on something else) is the return you receive from a risk-free investment. Academics consider the US Treasury Bill a good proxy for this risk-free investment. In case you’re wondering, the 30-day Treasury Bill (T-Bill) rate is currently returning 2.44%. So, if you’re willing to give up the use of your money by investing it, and you’re certain that the investment has no risk (of loss), you can reasonably expect to earn 2.44% today. This is slightly better than the current rate of inflation (2%).

Now, what if you are willing to accept some risk? The formula tells us that you should be able to earn more return by investing in an asset that is not risk-free, i.e. where there is a possibility that you could lose some or all of your money.

How much return for how much risk?

Over time, we expect the stock market as a whole to generate a return that is greater than the risk-free alternative (i.e. T-Bills). The extra reward we receive for taking that risk is called the “market risk premium.” Let’s assume that the return of the broad market is 8.44% (to keep the math simple). We noted earlier that the return on the risk-free T-Bill is 2.44%. So, the current risk premium – what you can expect to earn from investing in the market, above and beyond the risk-free alternative – is 6.0% (8.44% – 2.44%). This is actually pretty close to the long-term historical risk premium calculated by academics and researchers.

So, we can now say that, if we are willing to invest in the broad market, we should expect to earn 2.44% for the loss of the use of our money, and another 6% for accepting the risk of loss from the stock market, for a total of 8.44%. We need to remember that this market risk premium (also called an equity risk premium) is the compensation we receive for taking market risk. We call the risk of any investment, compared to the risk of the market, Beta (β). So, the broad market is assumed to have a Beta of 1.

But how do we calculate the expected return from an investment other than the broad market? We need to know how risky it is compared to the market. Intuitively, we can say that, if an investment is riskier than the overall market, we should expect a higher return. Similarly, if the investment is less risky than the overall market, we would expect a lower return.

The fancy formula says that the return of an investment equals the (a) risk-free rate, plus (b) the risk of the investment, multiplied by the market risk premium. So, if we are considering investing in a stock we think is 50% riskier than the overall market, and we continue to use our same assumptions, we would expect to receive 2.44% for the loss of the use of our money, plus 1.5x times the market risk premium of 6%. The expected return would be 2.44% + 9% (1.5 x 6.0%) or 11.44%.

Now that we have our expected return for the investment, we have to discount the expected dividends and (capital) appreciation of the investment over our investment holding period (say, 1, 5 or 10 years), to arrive at a price for the investment. If the price we calculate for the investment is less than the actual market price today, we would consider the prospective investment “overpriced” and we should not invest in it. If the price we calculate is more than the actual market price today, we would consider the prospective investment “underpriced” and we might consider investing in it.

The Capital Asset Pricing Model profoundly influenced the study and practice of investing, and its developers – Harry Markowitz, Merton Miller, and William Sharpe – were awarded the 1990 Nobel Prize in Economics for their efforts.

Well, that’s enough for one day. We’ll discuss another important concept in financial economics, The Three Factor Model, in a future post.