Different Rates Change CAPM Market Portfolio?

Imagine the world of investing as a giant buffet. The Capital Asset Pricing Model, or CAPM, in its simplest form, tells us that every investor, regardless of their taste, should essentially be filling their plates with the same mix of risky dishes – what we call the market portfolio. Think of this market portfolio as a perfectly balanced smoothie, containing a little bit of every publicly traded company out there, weighted by its size in the market. According to the basic CAPM, everyone should be aiming for this same smoothie as the risky part of their investment plate.

Why this seemingly strange conclusion? Well, the CAPM rests on a few key assumptions to reach this point. One of the most important is that everyone can borrow and lend money at the same risk-free rate. Think of this risk-free rate as the interest you earn on a super safe government bond, or the interest you pay when you borrow money at the lowest possible rate. In the CAPM’s ideal world, it’s like everyone has access to the same magical bank with a single, universal interest rate for both deposits and loans.

This assumption simplifies things dramatically. If everyone faces the same cost of borrowing and the same return on lending, then when investors decide how much risk they want to take, they are essentially just choosing how much of this market portfolio smoothie to mix with the risk-free asset, like adding milk to the smoothie to make it less concentrated. If you’re risk-averse, you add more of the risk-free asset, making your overall portfolio less risky. If you’re more risk-tolerant, you add less of the risk-free asset, leaning more heavily into the market smoothie. But the core risky ingredient, the smoothie itself, remains the same for everyone.

However, what happens when our magical bank disappears and we enter the real world? In reality, borrowing and lending rates are rarely the same, and they certainly aren’t universal. Think about your own experience or that of someone you know. The interest rate you get on a savings account is generally much lower than the interest rate you pay on a loan, like a mortgage or a credit card. Furthermore, these rates vary depending on your credit score, the type of loan, and the lender. Someone with excellent credit might get a very low borrowing rate, while someone with a less stellar credit history will face a higher rate.

This difference in borrowing and lending rates disrupts the neat conclusion of the CAPM about everyone holding the same risky portfolio. Imagine two investors. Investor A can borrow money at a very low rate, perhaps because they are seen as very creditworthy. Investor B, on the other hand, faces a much higher borrowing rate due to perceived higher risk.

For Investor A, borrowing money to invest becomes more attractive. They can potentially leverage their investments in the market portfolio more easily and cheaply. They might be inclined to take on more risk, possibly even borrowing at the lower rate to invest even more heavily in risky assets beyond the standard market portfolio.

Investor B, facing a higher borrowing cost, becomes more cautious. Borrowing to invest is now less appealing due to the higher interest payments. They might prefer to lend more, seeking the relatively higher lending rate available to them compared to what Investor A might receive, and be less inclined to take on significant risk. Their optimal portfolio might contain less of the market portfolio and more of the risk-free asset, or even a different mix of risky assets altogether, to compensate for their higher cost of borrowing.

In essence, when borrowing and lending rates diverge, the ‘efficient frontier’ – the set of portfolios offering the best return for a given level of risk – becomes different for different investors. Investor A, with lower borrowing costs, faces a more favorable efficient frontier, allowing them to achieve higher returns for the same level of risk compared to Investor B. This difference means that the universally appealing market portfolio of the basic CAPM is no longer universally optimal. Investors will tailor their risky portfolios based on their individual borrowing and lending opportunities, alongside their risk tolerance and investment goals. The simple, elegant picture of everyone holding the same market portfolio starts to blur, reflecting the more complex reality of financial markets.