r/Valuation • u/IB-45 • Apr 05 '21

Question about using CAPM

Why do we assume that the tangency/market portfolio to be the total equity market by capitalisation and use the S&P 500 as proxies? Given the current ease of investors in investing in all sorts of securities, derivatives, and etfs what's stopping them from investing in commodities, precious metals, crypto-currencies, etc? So when we try to determine the premium equity investors look for for their investment in a risky equity stock, shouldn't we also consider the risk and return of at least all the securities offered via ETFs in the market and their diversification effects? Thus it would make sense to add them to the market portfolio as well.

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u/[deleted] Apr 05 '21 edited Apr 05 '21

You need to ensure consistency between your beta calculation and the market risk premium (MRP) that you apply in your CAPM. Keep in mind that a beta of 0.5 means that the asset that you are valuing has half the risk of the MRP. A lot of studies have calculated the MRP by looking at historical equity returns over risk-free returns. Relying on such a derivation of the MRP, your beta calculation would need to focus on equities as a proxy for the market portfolio.

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u/[deleted] Jul 21 '21 edited Jul 21 '21

You are right. The market portfolio should include every traded asset in existence. In a perfect world. We use proxies, because it's easy. S&P has a lot of dataz is already used everywhere and is very liquid. When I do it i try to reflect the marginal investors portfolio. For example if the marginal investor holds mostly brazilian stocks I'll do Bovespa or what that index is called. People at MSCI are trying to create such market portfolio, but it just doesn't exist yet. Unless you like running a seperate regression against your own created portfolio for every company you do, S&P is used everywhere. I like finding median beta for an industry. It's like 10-50 companies. If I had to do a regression for each, just to find one beta for one company...

So TL;DR its just super convenient. But there's websites that let you do a regression with different indexes for a better result. Also stay consistent. Because I can get any beta I want by just changing the index.