Bob Brinker's Marketimer

  Tuesday November 21, 2017

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CALCULATING EXPECTED RETURNS USING THE CAPITAL ASSET PRICING MODEL
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If you invest in Microsoft, what return do you expect on your investment?? 8 percent? 12 percent? 20 percent?? Would you expect different returns on the same investment in AT&T?? You should, because investments in these companies don?t involve the same degree of risk.? The CAPM provides an easy-to-use formula for calculating expected returns on individual stocks based upon their risk:?

Where:

• E(ri) is the expected return on stock i?

• rf is the current risk-free rate (the rate of return on investments with virtually no risk, such as U.S. Treasury bills)

• Bi is the beta for firm i?

• E(rM) is the expected return on the overall market

Suppose a technology company called Risky.com has a beta of 2, the expected return on the market is 10 percent, and the current risk-free rate is 5 percent.? What is the expected return on an investment in Risky.com?? Plugging these numbers into the formula, we find that we should expect a return of 15 percent for Risky.com.?

You now have an introduction to a concept that has helped many people achieve their financial goals.




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