Capital Asset Pricing Model

 

E(Ri) = Rf + Bi(E(Rm) – Rf)

E(Ri): The expected rate of return calculated based on the following criteria

Rf: The risk free rate of return

Bi: Beta

E(Rm): Is the current market return on investment

 

In this calculation, we are trying to see if the investment being analyzed worthy based current risk and return. I first want to explain a few factors here before I dive into the issue.

The beta for an investment is based generally on a major index like the S&P 500. It is comparing the change of value for the investment to the change of the overall market. Without going into how to calculate, an investment that moves exactly with the market has a Beta of 1, the exact opposite -1, half the market .5, etc... So you get the picture.

In a similar fashion, the market rate is based on the rate of return for the market as a whole. In other words, what can we expect to earn if we just invest in the market altogether? Again, this is using a major index like the S&P 500.

So let's do the order of operations. The first part is the difference in market rate and the risk free rate. This just means, how much more do we earn in the market than we do risk free. This is known as the market premium.

The second part is multiplying the beta to the market premium. This says that with X amount of risk/sensitivity we can expect to earn X amount.

Then we add in back in the risk free rate. This gives us our total rate of return we have to make if we want to do perform at or better than the market for the risk the investment holds.

If that was confusing, and I'm sure it was. Here is a visual

E(Ri) = 1% + 1.5(10%-1%)

1 is the risk free rate

1.5 is the beta

10 is the market return

Therefore, the required rate of return is 14.5% (Risk goes up, so does our required rate of return)

If we lower the beta to .5, the new rate would be 5.5% (Risk goes down, so does our required rate of return)

Now to the point…

I waited to explain the risk free rate so I could make my point. The risk free rate is based on government bonds. These are considered risk free because of the high credit rating of the US government. This is why the returns are so low. (low risk, low return)

Junk bonds are that of companies with low credit ratings that could possibly default on the debt and not be able to pay you back. Since these companies need money they are willing to sell bonds at a high rate of return just to get someone to buy them. This is just like if you go to get a car loan and have poor credit. The bank may give you the loan, but the interest will be very high. These credit ratings range from this level all the way to where the US government stands. STOOD.

Because now you know how the risk reflects the return, it is only natural that the rate would increase on the "risk free rate" since the credit rating of the US government has been downgraded. Therefore, impacting our rate of return required for investments. Let's bump up the "risk free rate" on our calculation and see what happens.

E(Ri) = 2% + 1.5(10%-2%)

14% is the new required rate of return

By doubling the risk free rate we decreased the required rate of return by .5%

In conclusion, it's a good time to look at investing in businesses that are doing well.

 

 

 

Home Interest

Being tax day, I thought it would be nice to post on a tax topic.  Before you stop reading, this won’t be about teaparty, flat tax, fair tax, or the royal wedding.  On the contrary, I would like to talk about working within the system we have.

For a long time the push was to get a mortgage.  The idea was that you could get a mortgage, get a tax deduction and make money when you sell the house. (Almost no matter how long you lived there.)  The reason was that home prices increased so fast that the home’s value would increase quickly to recover the closing cost on the house.  But that whole issue is for another day…

The issue I want to discuss is the tax deduction.  If you own a mortgage in the United States, you are allowed to take a tax deduction on the interest spent on the mortgage. 

The first issue with this is the misconception about what a tax deduction is.  A tax deduction does not mean you get the money you can deduct.  It simply means you are not taxed on it. A tax credit on the other hand is an amount that will directly reduce your tax bill.  Therefore, people often times think that having a mortgage is good because of the deduction.  But the problem is that you still have to pay the interest on it.

This leads me to next problem.  If the mortgage is considered an investment, which they once were, the increase in value of your house must be greater than the interest you pay on the mortgage.  Let’s look at an example.

If you buy a$150,000 house at 5% interest, the first year of interest would cost about $7,450.  Plus the sunken closing cost around $4,000.  In order to sell your house for profit, after one year, the house would have to sell for $161,450 or 7.6%!  Not likely in today’s housing market.

This example didn’t take out the savings you would have for the reduction of taxes, but I encourage you to look at you previous return to see the net effect of the interest you paid on your tax bill.  (Spoilier! It comes nowhere near the interest expense.)

However, if you don’t have a mortgage and you don’t have cash to pay for a house outright, what do you do?

Now obviously if you rent house, you won’t own any of it.  EVER.  However, if your life is unstable and you don’t know if you can live in a place for long, it may be a good idea to rent.

So, if you choose to buy a home and don’t think you’ll stay longer than five years or so, consider your home an investment where you won’t lose ALL your money.  If you pay a dollar, you may make $0.95 back on it.  But if you’re able to stay in that one horse town for a while you could make $1.05.  

The Grocery Game

When Heather and I go to the grocery store to stock up goodies for a week or two, we usually go out to eat before we do our shopping.  Our dinners, for two of course usually cost us (with tip) average $22.00 a meal.  This always makes me think about the efficiency of making dinner at home.  So let's think about this a moment.  If, a couple like ourselves were to only eat out for an entire week, what would that cost.  Let's say dinner is average of $22.00, lunch $15.00, and breakfast $4.00.  That's $41.00 a day/ $287.00 a week and that doesn't include the evening treats like cookies and ice cream. So I may have to add another $20.00 a week for some frozen yogurt/Baskin Robins...

So what can we save when we buy groceries?  This is the question that for us has yet to be fully determined.  For one thing, we still eat out atleast three or four times a week.  Not including lunch.  Which I can give a whole sermon on the benefits of bringing your lunch.  However, buying groceries has many different variables and angles to take for savings. 

For one thing, the ability to shop in bulk can help. We have a Sam's club card, and this is great for some things like paper products, and frozen foods.  We don't buy a great deal of things there because we don't have room for them...But buying in bulk can be beneficial, just make sure it is actually cheaper and worth while to store.

Health is another option.  I don't know if you've noticed it or not, but buying healthy groceries is expensive.  If all you care to do is fill the belly, you can get buy cheap. But premium products and fresh fruits and vegetables impact the bill.

To cap, we usually spend about $120.00 on groceries every other week.  This of course on top of eating out some as well. I just wonder how much groceries we would have if we only ate in and spent the same amount of money we do to eat out.  How about you?

Credit Card Algorythm

Most people don't know this, but not every 16 digit number can be a valid credit card number.  Here is how to tell if you have a valid credit card number. I should note that debit cards follow a different formula and this wont work for them...but anyway.  Take your credit card and write down all 16 numbers.  Below the first number, copy down the first number. On the second number, multiply that number by 2.  Finish the rest of the numbers in this pattern, multiplying every other number by two and copying down the others. The next step is to go through all the numbers and if the number is greater than 9, subtract 9 from it. (15-9=6) Now, total up all of the numbers on this last row you've created. This total number should evenly be dived by 10.  Therefore, if you changed one number on the card or transposed the number it would not be a valid card.

Enjoy :)

A Day Without the Internet

I guess internet withdrawals are only connected to a financial mistake if you forgot to pay the bill.  However, the more I think about it, the more connections to finance I can make.  First, not having internet at your disposal can mean that u missed the big stock market move that would have allwed u to cash in on the big upswing on your security. Also, to cut the internet off to your employees means that it takes them longer to write logs from their smart phone.