The risk and return tradeoff are a financial management principle that explains the potential relationship between the risk involved and the return resulting from such risky investment. Potential increase in return is closely associated with an increase in the investment risk involved while a low level of risk is associated with low returns on investment. However, despite the positive correlation between risk and return, there is no guarantee that greater risk will obviously result in greater returns. To minimize the possibility of loss, potential investors create a portfolio of different investments with varying levels of risk to spread the risk of loss.
Through diversification, investors can reduce the risk of their portfolio of investments without sacrificing their potential returns since in cases where the portfolio is fully diversified, the investor can add risky investment to earn a higher return. However, investors need to understand fully their risk tolerance level before constructing a portfolio of investments to avoid huge losses that may crumble the investment (Brigham & Ehrhardt, 2013). Therefore, the correlation of risk and return is very significant in financial management since investment is all about the risk associated with it and the level of returns expected from committing resources to a particular investment.
Despite the urge of the investors to get rid of all the risks in their investments, it stands out to be difficult to accomplish such desire. Therefore, investors have embarked on determining the rate of return that they expect as a perfect compensation for the risks involved in the investment (Brigham & Gapenski, 2014). The Capital asset pricing model (CAPM) is commonly used by investors to compute the investment risk and the rate of return on investment that an investor expects.
CAPM uses beta as the only measure of the investment risk since it measures the stock volatility thus serving as a good measure of the investment risk involved. The computation begins with the risk-free rate that is also subtracted from the expected return from the market to get the equity market premium (Brealey, Myers & Allen, 2011).
E(ri) = Rf + Bi *(Erm-Rf)
Where:
E(ri) =return required of financial asset i
Rf = risk-free rate of return
Bi = beta value for financial asset i
E (rm) = average return on the capital market
This mathematical model is used to describe the association between the risk and return in a market at equilibrium by analyzing the risk involved and the asset returns for the investment. Financial managers use this model to supplement other financial management techniques in their endeavor to develop logical cost of equity computations.
The empirical evidence of the capital asset pricing model provides that the model considered good apart from cases where security market line intercept is approximated to be 3 to 4 percent above the real risk-free rate (Kaplan & Atkinson, 2015). It proves its consistency with the CAPM that people cannot acquire money at risk-free rate in the market. The empirical evidence of the capital asset pricing model is justified by the fact that it is not possible to observe the correct market portfolio, or observe the right expected returns from an investment thus it is very difficult to test the relationship between risk and return of an investment (Agrawal, Mohapatra & Pollak, 2012). Therefore, these evidence shows that there are numerous shortcomings in the interpretation of the model due to the apparent inconsistencies in the measurement of risk and return.
The international academic community is turning away from the capital asset pricing model because of the numerous assumptions associated with the model which renders its outcome weak for decision making. The main assumptions of CAPM are that the investors hold much-diversified portfolio of investments hence they only require a return for the systematic risk assuming that the unsystematic risk is eliminated from their portfolios (Brealey, Myers & Allen, 2011). The other assumption of the model is that the investors have the same period for the purpose of evaluating the information concerning their portfolio of investments hence it provides a single period transaction time frame that is strictly followed by all the investors.
The assumption of the CAPM that people can acquire money at the risk-free rate gives the least level of return accepted by investors that may not be necessarily true. The model also makes the assumption that there exists perfect capital market where securities are valued correctly, no taxes involves as well as transaction costs. This assumption creates a virtual capital market that does not exist in real financial management field hence making it inapplicable (Christoffersen, 2012). These assumptions have resulted in numerous disadvantages and limitation of the use of the capital asset pricing model that makes more of the academic community around the world to turn away from the CAPM model.
Assigning of values to the CAPM, such as the risk-free rate of return, the market return and the equity beta is based on estimations which may be prone to errors. Most of the values assigned to these model are subject to changes over time in the economic circumstances thus holding them fixed may not produce the desired information for making viable investment decisions. Another issue arising from the use of the CAPM model is its use in the calculation of project-specific discount rate (Lumby & Jones, 2007). To find a suitable beta for the model, companies are forced to average its entire equity beta in various company projects which may turn out to be difficult to obtain due to lack of adequate information about relative shares of a company.
Another disadvantage of using the capital asset pricing model while appraising investments is it has a one horizon. This is because the project may be a multi-period investment appraisal that is undertaken for many periods hence assuming constant success in the future may not be the right measure of the return on the investment (Brigham & Ehrhardt, 2013). Considering these assumptions, limitations and shortcomings of the capital asset pricing model, many financial scholars are turning away from the use of the model in financial management and finding new techniques to replace or correct the errors in the model.
Despite the limitations associated with capital asset pricing model, this model remains to be the best technique for establishing long-term tradeoffs between risk and return in financial markets. The ability to compute the expected rate of return using this model has made many of the corporate managers adopt the capital asset pricing model as their preferred model for establishing the relationship between the level of risks involved in a portfolio of investments and the expected return from investing in such portfolio (Christoffersen, 2012). The model considers the systematic risk only since in reality most of the diversified portfolios created by investors are free from unsystematic risk.
References
Agrawal, M., Mohapatra, D., & Pollak, I. (2012). Empirical evidence against CAPM: relating alphas and returns to betas. Selected Topics in Signal Processing, IEEE Journal of, 6(4), 298-310.
Brealey, R. A., Myers, S. C., & Allen, F. (2011). Principles of corporate finance, concise edition. Boston: McGraw-Hill.
Brigham, E. F., & Gapenski, L. C. (2014). Intermediate financial management. Chicago: Dryden Press.
Brigham, E., & Ehrhardt, M. (2013). Financial management: Theory & Practice. Cengage Learning.
Christoffersen, P. F. (2012). Elements of financial risk management. Academic Press.
Kaplan, R. S., & Atkinson, A. A. (2015). Advanced management accounting. PHI Learning.
Lumby, S., & Jones, C. M. (2007). Corporate finance: Theory & practice. London: Thomson.
