About half of all American households are invested in the stock market through self-constructed portfolios or mutual funds. In most cases, people wash their hands of investment decisions by entrusting their savings to finance professionals. With stocks routinely taking investors for roller coaster rides, it's important to know what constitutes a fair return on equity investments.
Risk vs. Return: The Capital Asset Pricing Model
A stock's fair return can be approximated using the capital asset pricing model, or CAPM. The model's major premise is intuitive: Investments carrying higher risks should reward investors with higher expected returns. A stock's expected return is determined by three factors: the risk-free rate, the stock's beta and the market return. The risk-free rate refers to what investors can earn through safe securities such as U.S. government debt. The beta refers to how much a particular stock fluctuates relative to other stocks. And the market return refers to a relevant benchmark, or a basket of similar stocks. The CAPM formula is: expected return = risk-free rate + beta * (market return -- risk-free rate).
An Individual Stock Example
Imagine that an investor is considering buying Microsoft stock. She starts by researching the risk-free rate and finds that the one year U.S. Treasury note carries a yield of 2.5 percent. Next, she learns that the stock trades on the Nasdaq, which investors believe will generate annual returns of 12 percent. Finally, she estimates that Microsoft's stock has a beta of 1.2, meaning that on average, when the Nasdaq gains 1 percent, Microsoft's stock gains 1.2 percent. Plugging the information into the CAPM formula tells the investor that she should expected an annual return of 13.9 percent.
Alpha: Deviating From Expected Returns
When actual returns match expected returns, investors earn a fair return. But returns often stray from expectations. In such cases, the difference between the actual and expected return is known as "alpha." Savvy or lucky investors can pick underpriced stocks that outperform and generate positive alpha. Poor investors are stuck with underperforming stocks. Those who can consistently outperform the market are few and far between and include investors like Warren Buffet.
Long-term Stock Market Performance
Generally speaking, expected returns are more likely to be realized over long time horizons due to smoothing effects. For example, the S&P 500's return from 1950 to 2009 is 11 percent, which is in line with how people expect the overall stock market to perform. But looking at shorter time periods reveals a different story: The 1950s saw red-hot returns of 19.3 percent, while the first decade of the new millennium shocked investors with -5.1 percent returns.
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