Introduction
Over the years the CAPM model has been used by investors when considering investing in multiple projects. The model provides a way to enable investors to make an estimation of the expected return that can be arrived at from investing in a security. It bases its assumption on the fact that investors expect an additional return when they choose to invest in risky securities. Therefore, investors choose to diversify securities in a portfolio so as to earn more returns. It is therefore advisable for individual investors to use the model for the following reasons:
It Is a Good Method as Compared to Others
When considering other methods, the CAPM model enables an investor to make superior investment decisions. The use of WACC to represent the discount rate instead of using CAPM leads to an investor making wrong investment decisions. This is because a project within the portfolio may end up being rejected for the simple reason that the security Internal Rate of Return is lesser than the return estimated in WACC. On the other hand, if an investor uses the CAPM model, the IRR of a given investment in a portfolio is placed beyond the Security Market Line hence offering a greater return than the required so as to offset the non-diversifiable risk.
Helps in Determining if the diversification decision is viable
According to Pratt and Grabowski (2010), the CAPM model operates in an understanding that investors require additional income which should compensate the risk taken when investing in riskier securities. The model enables investors to determine whether the extra risk taken when investing in security is worth adding when an investor is coming up with a portfolio. Investors can also use the CAPM model to make a sound judgment of the entire portfolio risk to allow them to make adjustments to the portfolio if the changes seem necessary.
Enables optimization of risk-return relationship
When using the model, the investors are able to optimize the risk relation of a portfolio to enable investors to attain the lowest risk from the diversification of securities undertaken. This can be possible by estimating the expected return of a project using the formula of the model. The model places emphasis on beta hence guarantees the investor an informed decision in regard to diversification of securities. Various investors using the CAPM model choose to invest in little cost index finances instead of investing in stocks. The model enables the diversification of a portfolio.
Systematic Risk
In contribution to the topic of diversification of portfolios, Chisholm (2009), highlighted that the model only considers systematic risks hence reflecting reality in the real world where unsystematic risk should be completely eliminated. This enables investors to make an estimate to determine if undertaking a specified project would be worth in regard to the diversification of a portfolio. The CAPM model assumes that the unsystematic risk should be managed by either the individual investor or the company offering the security and therefore does not need paramount consideration in regard to the estimation of a project’s expected return.
Conclusion
Research conducted by scholars has shown that the CAPM model is the best method to be used by investors when evaluating investment decisions. The model enables investors to realize how diversification of a security’s risk arrangement reduces the overall risk. Until another new method is introduced CAPM model will continue to be a useful evaluation toolkit that enables investors to make informed investment decisions.
References
Chisholm, A.2009. An Introduction to International Capital Markets: Products, Strategies, Participants. New York: John Wiley & Sons.
Pratt, P., S. & Grabowski, J., R. 2010. Cost of Capital: Applications and Examples. New York: John Wiley & Sons.