CAPM, which stands for the capital asset pricing model, divides an investors portfolio into two groups. The first group consists of a single, riskless asset, and the second group consists of a portfolio of all risky assets. The latter is called the tangent portfolio. It is also assumed that all investors hold the same tangent portfolio. The degree of risk of each asset within the tangent portfolio is equivalent to the co-variability of the market portfolio. When these two groups of assets are combined, the frontier portfolio is created. Furthermore, there are two types of risks: systematic risk, which cannot be diversified away, and non-systematic risk, which can be diversified by holding the frontier portfolio. This is the main advantage of the CAPM : It considers only systematic risk, i.e. the risks only associated with the market in question.
Disadvantages of CAPM
The CAPM entails several disadvantages. One of these is assigning values to the rate of return of the risk-free asset, the tangent portfolio's rate of return as well as risk premiums. The risk free asset is often in the form of government bonds, bills or notes, which are often assumed to be very low in risk. The yield of these securities constantly change as they get closer to maturity. Furthermore, the return on risky assets such as stocks can be negative if falling share prices outweigh the dividend yields. Risk premiums also vary with time. The dynamic nature of the market thus has a drawback on the static nature of the CAPM.
DDM stands for the dividend discount model. It is far less complex than the CAPM as it is only focused on stocks rather than an entire investment portfolio. Specifically, it is focused only on stocks that pay dividends, which tend to be derived from stable and profitable companies such as blue chips. It uses the definition of stock value to be the current dividend per share, divided by the discount rate minus the dividend growth rate. It therefore uses both investor perceptions and market data for determining the value of stock. The DDM model thus offers the ability to factor in investor expectations while using a very simplified selection of inputs and variables.
Disadvantages of DDM
The DDM model has several drawbacks. The main disadvantage is that stock valuations can be highly sensitive the small changes in inputs. A slight modification of the investors discount rate can greatly effect the value of a security. Furthermore, investors may over rely on the model as an valuation tool when it is still technically an estimator in its purist sense.
Practical Use of a CAPM
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Limitations of the CAPM
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