The capital asset pricing model, CAPM is a centerpiece of modern financial economics. Themodel gives a precise prediction of the relationship that we should observe between the risk of anasset and its expected return. This relationship serves two vital functions. First, it provides abenchmark rate of return for evaluating possible investments. Second, the model helps us tomake an educated return on assets that have not yet been traded in the marketplace. Intuition: Risk-averse investors measure the risk of the optimal risky portfolio by its variance. Inthis world, we would expect the reward, or the risk premium on individual assets, to depend onthe contribution of the individual asset to the risk of the portfolio. The beta of a stock measuresthe stock’s contribution to the variance of the market portfolio. Hence we expect, for any asset orportfolio, the required risk premium to be a function of beta.8.What does the life cycle savings and investment theory address?
Let us suppose, for simplicity, that the only investment opportunity is to save or borrow at 0percent interest. The lines labeled “advice” a simple proposed financial plan: save $10,000 a yearwhen young, save $20,000 a year during prime earning years, and withdraw $50,000 a year inretirement. It is easy to verify that this plan works (for the age ranges savings at retirement equal$750,000, which, divided up over the remaining 15 years, allows withdrawals of $50,000 a year.How good is this proposal? Standard approaches to financial planning would focus on whetherthe investor could afford to save enough or whether the $50,000 would be enough to cover costsand desired consumption in retirement. What does the life- cycle theory say about this proposal?We distill three principles from the life-cycle approach:Principle 1: Focus not on the financial plan itself but rather on the consumption profile that itimplies. In this example, we can easily calculate consumption is equals income less savingsduring working years and withdrawals less health expenses in retirement.