Our Alternative to CAPM

June 26, 2009 · Leave a Comment

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Some readers have been asking about the CAVM model we derived as an effort to be used in place of CAPM. Our model simply helps evaluate the expected return for a particular investment given the risks involved. Contrary to what most investors believe, risk cannot be quantified by a single number, so the goal is not to evaluate risk to a high degree of certainty. Instead, it provides a picture of the symmetry (or asymmetry) of the investment payoff we are trying to evaluate. This method is similar to the method used by gamblers to asses a wager’s payoffs. 

According to Edward Thorp, the fundamental problem in gambling is to find positive expectation betting opportunities. The analogous problem in investing is to find investments with excess risk-adjusted expected rates of return. This simple premise is what allowed us to develop the Capital Asset Value Model (CAVM), which we first explained on a previous post.

The model is derived from the following thought experiment:

Imagine that we are faced with a wager on a biased coin. Namely, our job is to bet money on the probability that a coin lands heads when in fact, both sides of the coin are tails. How much should we bet? Common sense dictates that no bet is placed, or wager is zero, because the probability of loss (risk) is 100%. Therefore, our expected winnings would be zero at maximum risk. Now imagine that we are to place a wager on the probability that the same coin lands tails. On this case, common sense dictates that we wager 100% of our money, since the probability of loss (risk) on such biased coin would be zero. In other words, our winnings would be maximized when the risk is zero.

As we pointed out in our introductory post, we have derived an equation for this line. Generally, the expected return is a function of both the margin of safety and the certainty to which our analysis on the investment is correct. The result can be visualized graphically as presented below.

 chart

In our opinion, the strength of CAVM is that it defines risk properly. As such, risk on a particular investment cannot be quantified with definite precision, but the slope of the risk-return line can be helpful in evaluating whether our odds are favorable or not. Specifically, the bigger the slope of the risk-return line, the bigger the possibility of above-average returns. As shown below, the asymmetry (good payoff even at high probability of loss) of the investment represented by the green line makes it more favorable than that represented by the red line.

chart2

The model’s application to a stock portfolio has been presented on previous posts. But the same type of analysis can be performed with other investment vehicles such as real estate and private equity.

Categories: Value Investing
Tagged: CAPM, CAVM, investments, value model

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