Data Mapping

As financial firms seek to better model and predict risk, especially across a variety of portfolio holdings, many economists are turning back to the Capital Asset Pricing Model (CAPM). During the recent market downturn, many investors sought increased returns, while paying little attention to the true risk of the underlying investments; CAPM, on the other hand, seeks to help structure portfolio allocation decisions based upon market risk factors which cannot be strictly controlled.

The model formed the basis for innovations in financial theory, which were recognized with a Nobel Prize awarded to economists Harry Markowitz and Merton Miller. In particular, the model allows for the expected returns on a class of assets to be the base interest rate (essentially, the rate on government bonds – the risk-free rate) plus the risk premium factors (scaled by beta, or the movement of the asset relative to the larger market.) Over the past few years, many forecasters created models in which the risk factors were under-stated based upon the belief that returns on investments would continue to grow (especially in real estate) while the overall health of the market would remain steady. In fact, these forecasts were created in order to justify securitization of assets, by passing them on to 3rd party investors. Modern portfolio theory, in practice, established an equilibrium of returns relative to risk; any anomalies in return will be adjusted based on improved information – where risk is greater, prices of assets will fall. One of the bases of portfolio theory is optimization – financial analysts seek to find the “efficient frontier”, which is the highest level of return for a given level of risk allowance – diversifying assets across several classes and markets, while adequately accounting for risk is the direction that financial models are beginning to return to.