- It's time to talk about what is probably the most famous finance model, the Capital Asset Pricing Model or the CAPM. Start with some simple insights. First of all, we know that we're risk averse, you've got to pay us to accept risk. Some risk can be eliminated through diversification. But there are some risks that cannot be eliminated through diversification, systematic risk. Let me tell you what those risks are. When the economy moves broadly, everybody gets impacted.
Everybody floats up, everybody floats down. For example, in the years 2000-2002, in the wake of the busting of the Internet bubble, all of us felt our economic circumstances go down. There was no way to protect yourself from that through diversification because everybody was impacted. 2008 and 2009 there was a global economic recession. Everyone, everyone in the world was impacted by that recession. There was no way to avoid that risk. So there are some risks that cannot be avoided through diversification because everyone is impacted.
That risk, the risk that cannot be avoided through diversification is called Beta Risk. Beta, computationally, is the covariance between a company's returns and the market returns divided by the variance in the market returns. Well, that's mathematics, that is statistics. So let's forget about that and make sure we've got the concept. Beta measures the market-wide risk that cannot be eliminated through diversification because it happens to everybody. Everybody is impacted.
Let me give you an example of what I mean. Cash has a beta of zero. Here's what that means. Imagine a dollar bill. Ignore for a moment the impact of inflation, the impact of foreign currency fluctuations. A dollar bill is a dollar bill. And if the economy is strong this year, a dollar bill is still a dollar bill. It's worth a dollar. If the economy is weak this year, this dollar bill is still worth a dollar. So that item, that investment, the investment in that dollar bill, is immune to fluctuations in broad economic forces.
It's still just a dollar it has a beta of zero. It's value is not related to the market at all. Let's say, instead, that I have a broad investment portfolio. I bought a little bit of this company, a little bit of that company. I own lots of companies in the economy. Well when the economy goes up, my investment portfolio will go up. When the economy goes down, my investment portfolio will go down. That means that my investment portfolio, my collection of investments, has a beta of one. If the market goes up 15 percent, my investments will go up 15 percent.
If the market goes down by 10 percent, my investment portfolio value will go down by 10 percent. My investments move with the market. What would it mean for a company to have a beta of more than one? Well, I'll give you an example. The home building industry has a beta of more than one. Think about your local community. When the local economy is doing well then houses are going up all over the place. Builders are very busy. They're building apartments, they're building residential homes. You try to get some repairs done and hire a craftsman, you can't get a craftsperson because they're all busy building houses.
So when the local economy goes up a little bit, home builders really benefit. On the other hand, when the local economy goes down a little bit, you see all those construction sites slow down. Home builders are very sensitive to fluctuations in broad economic movements. That's reflected mathematically in the fact that they have a beta more than one. Beta reflects the amount of risk that a company has that's tied to the market risk. How do they go up and down in association with the broad economy? Here are some actual companies.
Let's talk about Ford Motor Company. If you're fearful of your job, if the economy is going down, and you're fearful of a recession, you're not going to run out and buy a new car. So when there's a little downturn in the economy, Ford Motor sales go down. But then when the economy goes back up, lots of people want to buy cars. They've got this pent up demand. So Ford Motor Company sales go way up. Ford, when the economy goes like this, Ford Motor goes like this. That's reflective in a high beta. Bank of America. Banks recently, especially large banks, have started engaging in more risky behavior.
They're selling derivatives, they're trading derivatives, and collateralized debt instruments, and mortgage-backed securities, which all sounds very exotic and scary. And it is scary because what it has done is this: When the broad economy is doing well, banks, large banks like Bank of America, do great. When the economy goes down, these banks get killed. They get hammered. They have a large beta risk. When the economy goes like this, the prospects of these banks go like this. Companies with beta of close to one.
This reflects the broad importance of technology in our economy. Google, Microsoft, Apple, their prospects, their economic prospects, their economic performance pretty much tracks the economy. When the economy is strong, these companies are strong. When the economy goes down a little bit, they go down a little bit. They have betas of one. What does it mean for a company to have a beta that's quite low? Well, McDonald's and Walmart have betas that are quite low because even when the economy is down, you need to buy clothes, you need to buy groceries and you need fast food.
So economy is down, you still need those things. The economy is up, you still need about the same number of things. When the economy goes up, you don't all of a sudden decide that you need five Big Macs a day. One will probably still do. So the fluctuations of performance of Walmart and McDonald's are almost independent of what happens in the broad economy. One other industry that is almost immune from broad economic effects is Altria. Altria you may know by its older name Phillip Morris. They sell cigarettes. And even when the economy is down, people still need to buy cigarettes.
Even when the economy is up, they're still buying about the same number of cigarettes. A beta close to zero. A low beta means a company is not really impacted by broad economic movements.
- Understanding financial statements
- Managing finances in the short term
- Analyzing risk and return
- Obtaining short-term and long-term financing
- Understanding the stock and bond markets
- Comparing the Facebook and Microsoft IPOs
- Working with financial institutions
- Using capital budgeting
- Creating simple personal saving and investment plans