The Capital Assett Pricing Model (AKA How to Choose an Investment)

I have been in the teaching business for many years, and one of the hobbies I acquired during that time is making a complicated subject simple enough that almost anyone could understand it.

Today, I am talking about the Capital Asset Pricing Model.... and by the end of this post, you will probably be able to understand it.... (I hope)

But why do you care?
Good question.

If you plan on making any investments during your lifetime (including buying a home), a familiarity with this topic will likely greatly help you make your investment decision.

So...buckle up, here we go.


The Capital Asset Pricing Model, or CAPM (pronounced "kap-em") is a visual tool that helps show how the rewards from making an investment are usually connected to the risk of that investment.

Here is a CAPM chart. On the vertical (or Y) axis, you can see the annual returns (aka income or growth) of an investment, and along the bottom (X axis) you can see the riskiness of that investment.The red line is called the Security Market Line and the dots on it represent investment choices.

Now, lets look at the where the red line is touching the Y axis (far left). You can see that the return of that investment choice is 2%, while the risk is 0. This is what we call the "Risk Free Rate" (or RFR). This is the amount you could make on your money without taking on any risk at all.  Examples of investments of this type would be your bank account, government savings bonds, etc.

But let's say that you were not happy with getting only 2% return on your investment. Let's say that you wanted to make more.You could invest your money in something that averages around 8% per year (which sounds much better than 2%), but hold on....it's more risky. You would expect, no wait, demand higher returns on investments that were more risky. So the additional return is a lot like compensation for taking on more risk (meaning more wild swings in returns and a higher chance of losing your investment).

So, the 8% choice is more risky... but how risky is it?

Well, here is how risk is measured. Do you see the 1.0 that is directly under the 8% investment dot? And do you see the Beta β as well? Beta is the term that financial people use to represent riskiness. A Beta of 0 means that the investment has absolutely no risk (your investment and the returns are absolutely certain to come back to you). A Beta of 1.0 however is average riskiness (when you take the whole economy into account) and a Beta of 2.0 would mean that the investment is twice as risky as average (like a tech stock).

So if you hate risk, you can invest your money at 2% (or whatever the current RFR is), but if you are willing to take on more risk than the average investment has in order to get higher rewards, then you could invest your money into something that had a Beta of 2.0 or even 3.0.

So, the first lesson to remember is that if someone (like a financial adviser) tries to get you to invest in something that has high returns, check to see if the risk is high too..... (it probably is)

So, how do you compare an investment that has a return of 6% and 12%? Wouldn't you say that the higher return option is better?

Well, not so fast.
If you look on the chart, you can see that the 6% option has a Beta of 0.75 and the 12% option has a Beta of 1.5. In financial terms, we would say the the two investments have equal value. One has lower returns and risk and one has higher returns and risk. You may have a preference for one over the other, but they are basically the same.

Now, let's complicate things a bit.

Do you notice that there are dots (investment choices) all over the chart?
This is how the world of investments actually works.

Although you would expect that returns and risk would all sit right on the line, this is not how it always happens. Sometimes you will see investment choices that are above the line (the reward is higher than the risk would suggest) while at other times you see choices that are below it (meaning that the returns are lower than you would expect, given the riskiness)

If an investment provides greater returns than its risk level would indicate, we would say that this investment has "outperformed the market" (and you as the investor would be happy). If the opposite is true, then we would say that the investment had "underperformed". Obviously, investors are looking for the former and trying to avoid the latter.

Any time you are making an investment decision, you should consider not just the potential payoff of your choice, but the possible risks as well. Many investors have chosen investment options that advertised high returns, but have done so without considering the riskiness of those options. This often results in unexpected swings in returns, and many sleepless nights.

So, in conclusion, before investing your money, try to compare both the reward and the risk of your choices. Look for choices that will likely outperform the market, but only at a level of risk which would allow you to sleep at night.

Climbing the Property Ladder

Amanda Asks: When is the 'right time' to move from a condo to a house? is it always smart to move "up" once your "foot is in the door" of the real estate market?

Good question, and I have encountered questions like this many times.

But, before I answer this question about when it is wise to move from a condo to a house, I will answer a question I have run into more than once, and that is whether it is a good idea to buy a condo at all.

I understand that in many urban markets, unless you have a huge downpayment and a great job, your options are 1.) condo or 2.) rent for the rest of your life. A condo, for many is the only way to stop renting and get into the real estate market (I address the pros and cons of buying vs. renting here).

However, if you find yourself with a downpayment and you can make the monthly payments (the interest rate time bomb is explained in part here) I would still caution against buying a condo.

Yes, yes, I know, condos are so nice. You don't have to mow the grass or shovel the walks and usually, they are nice and in a good location..... but, (and it's a big one) you are getting into an investment (as well as, I would argue, a huge liability) that you do not control. If the group of owners decides to replace the roofing, or the city finds problems with the HVAC system, the condo board will pay out a lot of money to fix the problem.... so far so good, that is what your monthly condo payments are for.

But, what if two (or three) problems arise around the same time? If the reserve fund runs out (and it happens more than you might think), you will be given a letter demanding thousands (often tens of thousands) of dollars from you in the next month to pay for the repairs or upgrade. This is called a Cash Call, and they can be horribly painful.

Now, if you owned your own home and you had, say, a roofing problem, you could ask a cousin, neighbor or friend to help you, buy the shingles and a few pizzas and reroof your house in a day for a quarter of the price you would have paid the condo association.

Even if you have to hire a contractor to do it for you, you could shop around for a better price and (here is the big one) you could choose to do (or not do) the repairs when you want (ie, when you can afford it).

Instead of buying a condo, let me suggest another option that is cheaper, offers more privacy and lets you grow your equity more quickly.

Now......I know that this is not a popular option, but this is a money blog and not a "how to look good in front of your friends and family" or "how to live in a really nice place right now" blog.

Here I go......Mobile homes...used ones

Yes, I said it.

Mobile homes often cost way less than a condo, you fully control the living unit (although you pay a monthly lot rental) and you would live in your own space.

Detractors would say that you would lose all that lot rental each month, but my response is that people paying mortgages lose much more in interest payments.

If you doubt my advice, set your personal feelings about living in a trailer park aside for the 5 minutes it would take you to crunch the numbers.
After you see that it makes sense and you still want to live in a condo, then fine, but at least you will acknowledge that living in a condo is a personal and not a financially driven choice.

Living in a mobile home is not for everyone, but it was a good start for my family and it is for millions of others.

Now, onto the question about climbing the property ladder:

When to sell one place and move into another is a very complex choice. It can be affected by the size of your family, your income, your lifestyle choices and the property values in your area. However, I will say this, I believe that most North Americans try to move up into better living spaces too early and too often. People decide that they "can't" live in their current space any longer and "need" something bigger, nicer, etc. (I imagine that they are comparing their current home with the one their parents live in, and they want one like that now instead of saving up for it like their parents did)

With interest rates being as low as they are, I imagine that there are many people who are looking at their current mortgage payments and realizing that they could live in a larger house for the same payment as they are currently paying.

While this may be true, interest rates are not going to stay low forever and you could be getting yourself into trouble if you get a larger mortgage when the rates are at all time lows.

The average North American pays twice as much of their income in mortgage payments each month as people did 50 years ago. We have become accustomed to being "house poor", but finding yourself in a tight cash flow situation (and one that you know will last for many years) has a way at eating away at your quality of life in a pretty serious way.

Here is my advice; if you can move from your current place to a home where you would rather live, and you can afford it now and in the future (even if interest rates rise dramatically), and it is a personal choice you wish to make, then go ahead, but I would suggest that before you do so, crunch the numbers to see if you really can afford it.

One last thought. I have found that for most big ticket purchases for which we make monthly payments, the recurring sting of payments lasts much longer than the new car smell.

When the Rental Market Chicken Comes Home to Roost

Shamon Asks:
In the event that interest rates rise, and, in the event this causes a significant deflation of real estate values, and in the event that this causes many homeowners to sell/walk away from/get foreclosed on - then how/what impact would this have on the rental market? On one hand, landlords would have higher carrying costs resulting in potential rental rate increases, while potential demand from would be renters (i.e. former home owners) would also increase. They'd have to live somewhere. Naysayers would probably argue that the renters would not pay these inflated rates...

Thanks for the question Shamon.

Nearly 70% of Americans own the home in which they live. This is because home ownership is almost sacred in North America. Almost everyone who can own a home does so. Most people consider home ownership to be a good idea and few even bother to (or think of) crunching the numbers to determine whether this is true or not in their case.

On the other side of the pond, only 30% of the Swiss population owns, while most rent. They consider home ownership to be a poor use of their money.

So which is it? Who is right: the Americans or the Swiss?

Unfortunately, (and it pains me to say it) the Swiss.

After all costs are considered, home ownership is often of marginal investment value. Now, people have made a lot of money on houses over the last 20 years, but that has been because of an abnormal period of artificially low interest rates which made it much cheaper to carry a mortgage, which had the predictable effect of increasing demand and raising prices, which made owners a lot of money. (you can read about this period in history here)

Over the last several decades, because of low interest rates , house prices rose. Also, because few people wanted to rent, rents have been somewhat stagnant.

Here is how the rental business should work (and how it works in Switzerland): a property manager calculates the costs of owning and maintaining the home, adds a bit of profit, and that is the rent price they will charge to tenants.

Here is how it has been working in North America: Because of low interest rates and how badly people want to own their own home, home prices have increased. This leaves owners of rental units competing with each other for a small number of people who want to rent their homes, while paying relatively high costs and being able to charge low rents.

This is about to change.

As interest rates rise, demand for home ownership will decline.
As inventory of  homes on the market increases, home prices will drop.
As people walk away from their homes (or lose them), demand for rental homes will increase. (This could also result from fewer and fewer people aspiring to home ownership, due to recent declines)
As landlords buy cheaper houses and rent them out to more and more people who are demanding rental units, rents will rise.

Now, landlords who bought their rental units at high prices during the bubble might not be able to charge rents high enough to cover their costs, let alone make a profit, but as the overpriced inventory works through the system (ie, default, short sales, and bankruptcy), eventually most rental units should become profitable.

So, having made that caveat, I will predict that profitability is about to return to the rental market.

Cheap Money is the Opium of the Masses

Blake asked about the prudence of buying rental property in the current economic environment.

Thanks for the question Blake.

 There are many kinds of recreational drugs. Some begin destroying your body in obvious ways immediately (think crack or meth), others take a while and then might kill you suddenly (like the stroke you might someday have from smoking opium).
The advantage to the drugs that show horrible and obvious signs of damage immediately is that it give the user pause for thought regarding their current "recreational" activities. Conversely, the drugs that start killing you in unseen ways might give you the impression that they are not hurting you at all, making you feel safe to continue taking them.

North America have been on a 20 year drug binge, but the drug of choice has been the "few side effects, followed by a stroke" kind.

After the dotcom crash in 2001, western governments reduced interest rates many times in order to "stimulate"* the economy.

• *Economists who follow "Keynesian" (named after a British economist named John Maynard Keynes) economics believe that governments should "stimulate" their economies by lowering the rent people pay when they borrow money (AKA interest rates) and spending more (so more money is flowing through the economy) when times are tough, and raising interest rates and spending less when times are good. This policy works well in theory, but what often happens (and what happened over the last 20 years) is that governments will reduce interest rates and spend more when the economy is slow, but when it speeds up, they don't raise rates or cut spending (since these actions are not popular with the voters), which results in an "overheated" economy, inflation, over-investment,  and eventually a crash.

These declining interest rates made it possible for people to afford bigger and bigger houses with the same monthly payment. The result was an enormous increase in the amount of outstanding mortgage debt.

As people continued to buy houses, property values began to rise. As property values went up, people began to borrow more and more money to afford the bigger and bigger houses. Since the economy was humming along, unemployment was low, and economists were predicting the good times to last, consumers and investors felt comfortable taking bigger and bigger risks.

As people and companies borrowed more and more to build more and buy more, the business world responded by hiking production (which stimulated the economy even more). Demand was rising and supply was struggling to keep up. Homebuilders were building as fast as they could and they knew that all they had to do to make money was to build a house, so they built as many as they could, at higher and higher prices.

After a while the market hit a tipping point. Consumers who wanted houses and could afford them had bought them, but builders kept on building. Houses began to pile up. Houses began to sit on the market for longer and longer times.

Eventually, an awareness spread through the economy. The boom was over, house prices were not going to go up forever, and people who had bought multiple overpriced investment properties either became scared and dumped them onto the market at a loss, or held onto them until they could no longer afford the payments and lost them to the bank.

This rapid reduction in demand for houses at the same time as a rapid increase in the supply of houses on the market caused the prices to drop like a rock, and the economy went down with it.

Now, in a much different economic landscape, with asset prices dropping and unemployment rising, governments wanted to stimulate their economies, but alas, interest rates were already at very low levels and the government was already spending lots of money. The only options available were to drop rates even more and spend even more (ie, the bailouts of GM, Chrysler, the big financial firms, and "Quantitative Easing" #1 and #2)

So now, here we sit, with interest rates at record lows and governments spending money at record rates and trying to keep their economies as stimulated as they can.

But neither of these can continue forever.

Governments cannot spend forever, and they can't reduce rates any more than they already have.

When governments stop holding interest rates artificially low (either willingly or not) rates will climb... and they have lots of room to move.

Here is a chart showing mortgage rates for the last 60 years. (source Bank of Canada)

As you can see, where rates are now is lower than they have ever been. Eventually, rates will have to start heading back to more normal levels.

Over the last 60 years, the average mortgage rate has been around 8%. We are currently at about 4%.
If a person has a mortgage at 4% on a $300,000 house, they are paying $12,000 in interest per year or $1,000 per month. If Interest rates increase to 6%, then the interest payment would rise to $1,500 per month, and if rates revert to the historical average of 8%, the homeowner would be paying $2,000 per month in interest.

If you have a mortgage lock in for 5 years at 4%, and rates rise, your payment will not change initially, but when you go back to renegotiate your rate at the end of the 5 years, you would not be able to renew your loan at 4%. You would have to get a new mortgage at the rate available at the time.

Here is a suggestion: take your outstanding mortgage amount and look at your current rate. Could you afford to continue paying your monthly payments if rates went up to 8%?

Now here is another thought. When rates go up, and people began having to renew their mortgages at much higher rates, many homeowners will find their new payments unsustainable, and choose to sell their houses. This increase in the number of houses on the market will have the effect of reducing home prices.

Here is what I am predicting: Just as a reduction in the interest rates had the effect of increasing the affordability of houses, demand for houses and prices of houses, an increase in mortgage rates will have the opposite effect.... reduced affordability, reduced demand, and reduced prices.

So, Blake, buying revenue property could be a good idea, but I would suggest you get the property for a really good price and make sure that even if interest rates return to 8%, you could still make the payments.

If you can find a place that meets these criteria, you might be in a position to rent your houses out to the people who can no longer afford to live in their own.