- It's time to talk about what is probably
the most famous finance model,
the Capital Asset Pricing Model, called the CAPM.
This famous model starts with some simple insights.
We know that people are risk-averse
so you have to pay us to get us to accept risk.
Some risk can be eliminated through diversification.
But there are some risks that cannot be eliminated
through diversification.
We call this risk Systematic Risk.
For example, when the economy moves broadly,
everybody gets impacted.
Everybody floats up.
Everybody floats down.
For example, in the years 2000 through 2002,
in the wake of the bursting of the internet bubble,
all of us felt our economic circumstances go down.
And there was no way to protect yourself
from that through diversification,
because everybody was impacted.
In a similar fashion, during 2008 and 2009,
there was a global economic recession.
Everyone in the world was impacted by that recession.
There was no way to avoid that risk.
So there are some risks
that cannot be avoided through diversification,
because everyone is impacted.
The risk that cannot be avoided through diversification
is called beta risk.
Beta computationally, is the co-variance
between a company's returns and the market returns
divided by the variance in the market returns.
Now that mathematical, statistical statement
seems scary, but the idea is easy.
Beta measures the market-wide risk
that cannot be eliminated through diversification
because it happens to everybody.
Now let me give you an example of what I mean.
Cash has a beta of zero.
Here's what that means.
Imagine a dollar bill.
Ignore for a moment the impact of inflation,
and the impact of foreign currency fluctuations.
A dollar bill's a dollar bill.
And if the economy is strong this year,
a dollar bill is still a dollar bill.
It's worth a dollar.
If the economy is weak this year,
this dollar bill is still worth a dollar.
So that item, that investment,
the investment in that dollar bill is immune to fluctuations
in broad economic forces.
Cash has a beta of zero.
Now let's assume that I had a broad investment portfolio.
I bought a little bit of this company,
a little bit of that company.
I own lots of companies in the economy.
Well, when the economy goes up,
my investment portfolio will go up.
When the economy goes down,
my investment portfolio will go down.
That means that my investment portfolio,
my collection of investments has a beta of one.
If the market goes up 15 percent,
my investments will go up 15 percent.
Now what would it mean for a company
to have a beta of more than one?
Well, I'll give you an example.
The home-building industry has a beta of more than one.
Think about your local community.
When the local economy is doing well,
then houses are going up all over the place.
Builders are very busy.
So when the local economy goes up a little bit,
homebuilders really benefit.
On the other hand, when the local economy
goes down a little bit,
you see all those construction sites slow down.
Homebuilders are very sensitive to fluctuations
in broad economic movements.
That's reflected mathematically in the fact
that they have a beta more than one.
Beta reflects the amount of risk that a company has
that is tied to the market risk.