Am I overlooking something? If Beta measures only systematic risk (therefore assuming that all firm-specific risk can be diversified away), then why is the CAPM model used to estimate cost of equity? Isn't it a little misleading because some firms with very high firm-specific risk have very low systematic risk?

I'm thinking about biotech stocks vs construction stocks. Biotech stocks have very high firm-specific risk because the product might never be released to the public, but relatively little systematic risk because people need medicine in any business cycle. Construction companies on the other hand have very little firm specific risk, but high systematic risk since they will do poorly if the economy is not doing well. If you use Beta as a measure of risk, though, then the construction company will have a higher Beta than the biotech company due to higher systematic risk even though the biotech company is clearly a "riskier" investment. Why use CAPM used in estimating cost of equity? What am I missing?

Beta isn't perfect and it is a misleading measure of risk, which is one of the explanations for why the factor anomaly called "Betting against Beta" exists. It's still used though because it's theoretically correct. If every investor were completely diversified, Beta would be the measure of risk to use (assuming you could properly calculate it). Since no one is that diversified, then beta has its flaws.

The main point about beta you seem to be missing or not appreciating, is the fact that beta assumes investors are completely diversified.

edit: too much to explain

in a portfolio of 100000 stocks, a biotech stocks is less risky because it's less correlated with the other stocks in that portfolio :)

The beta calculation is a measure of covariability between market returns and the returns of a single stock. A short step away from the beta calculation is the calculation for the coefficient of determination between the two, or R^2. R^2 tells you what percent of variability in the stock is due to variability in the market. Variability in the market minus the risk free rate (the market risk premium) is THE measure of systemic risk, so beta tells you how much systemic risk is in any one stock's historical returns.

Firm-specific risk can be harder to quantify, because it can include acts of god, CEO plane crash or drug use, shady accounting, etc. You can't just say, "R^2 = 55% of the variability in this stock is systemic risk, so 45% is firm-specific risk."

Best Response

You should probably be asking: what use is CAPM for doing anything useful with the stock market?

• 2

7,548 questions across 469 investment banks. The WSO Investment Banking Interview Prep Course has everything you'll ever need to start your career on Wall Street. Technical, Behavioral and Networking Courses + 2 Bonus Modules. Learn more.

The CAPM assumes that investors are sufficiently diversified such that the unsystematic risk (firm-specific risk) becomes negligible as diversification will help "cancel out" the randomness from unsystematic risk. E.g. if you hold a portfolio of 30 assets, then the firm-specific factors for each company will sometime be positive, sometimes negative - due to the number of stocks held, such "random" variation should be cancelled out (same idea as for "random error" in statistics).

It of course relies heavily on that people are sufficiently diversified etc. etc. etc.

Having worked on both the fundamental and quant sides I can assure you that most calcs that are done in investment banking and equity research are basically broscience

Hope that helps

• 2

Because in theory, an investor should only be rewarded for holding systematic risk.

Having worked in fundamental research positions on the buyside for 3 years, I can tell you I've never used CAPM once.

Investors differ in their willingness to accept risk for a greater return. But if investors are willing to invest in the stock market, then they are willing to assume some risk. The capital asset pricing model provides is a consistent means to price risk premiums. If you are willing to accept higher risks to get higher returns, then it makes sense to demand a higher return for a higher risk; otherwise, why take the higher risk. By comparing the beta of a stock and its historical return with that of the general market, you can determine whether the return of a stock is worth its risk.

David Wilson
Criminal Defense Lawyer Indio
Personal Injury Lawyer Indio
http://cabreralawoffices.com/

david wilson123:

Investors differ in their willingness to accept risk for a greater return. But if investors are willing to invest in the stock market, then they are willing to assume some risk. The capital asset pricing model provides is a consistent means to price risk premiums. If you are willing to accept higher risks to get higher returns, then it makes sense to demand a higher return for a higher risk; otherwise, why take the higher risk. By comparing the beta of a stock and its historical return with that of the general market, you can determine whether the return of a stock is worth its risk.

Yes, if you think volatility = risk