Calculate Stock Portfolio Profitability

From this calculation we can expect that the “i” asset profitability should be 11.5%, considering that the rest of the premises remain unchanged. Here is how to calculate a stock portfolio profitability:

Similarly, we see that when “i” has a 1.5 beta, it risk premium is increased over the market risk premium in that same proportion (the larger the beta coefficient, the larger the asset’s risk premium and, therefore, the larger the expected yield will be; the lower the beta coefficient, the lower the required profitability will be).

The Security Market Line, which is represented by a straight line, clearly shows the expected yield in the market for each specific assed according to its non diversifiable risk level (beta) of each of the specific assets; showing its risk-earning relation. Therefore, every investment that comprises our efficient portfolio should be placed along the security market line.

As we can appreciate, assets with a beta over one have a larger risk than the market’s average and, therefore, their risk premium is higher than the market risk premium (and they will have expected yields higher than the market). For assets with a positive beta coefficient but lower than one, their risk premium will be lower than the market risk premium. While including these last assets in an investment portfolio reduces their total profitability, it also reduces the risk level we are assuming. In every case in which the beta is positive, the asset movement has a positive correlation with the market.

Assets with a negative beta move opposite to the market, but in the same proportion as that described to the positive betas; and those with a beta equaling zero have an absolutely independent profitability to the market’s movements.

While many current economists don’t agree with the CAPM, this is considered as a study base for investments to this date and the model closest to reality and investor behavior. We should mention that when Markowitz began formulating his theory, in the 50s, he was based in an efficient market in which investors unfold in just one market in each country and in a single time period (note the rigidities of the rime and today’s financial globalization), under the following premises (we should mention that in 1974, economist Bruno Solnik incorporated the possibility of investing in several currencies and markets at the same time to the CAPM formula, getting ahead of globalization):

·         Investors are rational people with a certain aversion to risk; therefore they will seek to maximize yield expectancies and minimize fluctuations.

·         The market is made of many small investors, where everyone has the same information about assets and the marker, besides having identical expectations about these assets.

·         The market offers no restrictions when investing, transaction costs and other expenses are not considered, taxes or additional charges of any kind.

·         No investor, by himself, can manipulate or control a specific asset’s price.