Comments on: Dimensional Fund Advisors Part VI http://wheredoesallmymoneygo.com/dimensional-fund-advisors-part-vi/ A personal finance blog written by Preet Banerjee Wed, 23 May 2012 05:38:46 +0000 hourly 1 http://wordpress.org/?v=3.1.2 By: Dimensional Fund Advisors Part V : WhereDoesAllMyMoneyGo.com http://wheredoesallmymoneygo.com/dimensional-fund-advisors-part-vi/#comment-975 Dimensional Fund Advisors Part V : WhereDoesAllMyMoneyGo.com Thu, 21 Aug 2008 17:38:04 +0000 http://www.wheredoesallmymoneygo.com/?p=785#comment-975 [...] CLICK HERE TO GO TO PART VI Share and Enjoy: [...] [...] CLICK HERE TO GO TO PART VI Share and Enjoy: [...]

]]> By: Preet http://wheredoesallmymoneygo.com/dimensional-fund-advisors-part-vi/#comment-974 Preet Thu, 21 Aug 2008 14:36:21 +0000 http://www.wheredoesallmymoneygo.com/?p=785#comment-974 @Michael James - that seems like a good solution. But CAPM in the real world has many other imperfections too (like not accounting for tax, assuming everyone is rational, and everyone is a price-taker, etc). But even the other "improved" models suffer from some of the same criticisms. I think it would be safe to say that you could make a case for using 5% in the other models as well though. @Michael James – that seems like a good solution. But CAPM in the real world has many other imperfections too (like not accounting for tax, assuming everyone is rational, and everyone is a price-taker, etc). But even the other “improved” models suffer from some of the same criticisms. I think it would be safe to say that you could make a case for using 5% in the other models as well though.

]]> By: Michael James http://wheredoesallmymoneygo.com/dimensional-fund-advisors-part-vi/#comment-973 Michael James Thu, 21 Aug 2008 03:29:54 +0000 http://www.wheredoesallmymoneygo.com/?p=785#comment-973 Institutional investors may have access to better rates for borrowing than individual investors, but they will still pay more than the risk-free rate because no lender would lend money to an entity for the same rate they could get by lending money to the government. I agree that CAPM assumes no transaction costs, but that is clearly just an approximation. To compensate for the error caused by higher borrowing rates and transaction costs, you can get quite good results by simply increasing the assumed risk-free rate in the risk-return calculations. In your example, if we use a risk-free rate of 5%, then the return needed to compensate for the 1.5 times more risky portfolio drops to 12.5% instead of 13.5%. My guess is that this is a better estimate of the required return. Institutional investors may have access to better rates for borrowing than individual investors, but they will still pay more than the risk-free rate because no lender would lend money to an entity for the same rate they could get by lending money to the government. I agree that CAPM assumes no transaction costs, but that is clearly just an approximation. To compensate for the error caused by higher borrowing rates and transaction costs, you can get quite good results by simply increasing the assumed risk-free rate in the risk-return calculations.

In your example, if we use a risk-free rate of 5%, then the return needed to compensate for the 1.5 times more risky portfolio drops to 12.5% instead of 13.5%. My guess is that this is a better estimate of the required return.

]]> By: Preet http://wheredoesallmymoneygo.com/dimensional-fund-advisors-part-vi/#comment-972 Preet Thu, 21 Aug 2008 02:11:13 +0000 http://www.wheredoesallmymoneygo.com/?p=785#comment-972 @Michael James - I agree that the risk free rate is not appropriate in the real world, especially for individual investors (it's even questionable for some institutional money I would imagine). However, the CAPM assumes no transaction costs among <a href="http://en.wikipedia.org/wiki/Capital_asset_pricing_model#Assumptions_of_CAPM" rel="nofollow">other things.</a> @Michael James – I agree that the risk free rate is not appropriate in the real world, especially for individual investors (it’s even questionable for some institutional money I would imagine). However, the CAPM assumes no transaction costs among other things.

]]> By: Michael James http://wheredoesallmymoneygo.com/dimensional-fund-advisors-part-vi/#comment-971 Michael James Thu, 21 Aug 2008 01:18:25 +0000 http://www.wheredoesallmymoneygo.com/?p=785#comment-971 I don't believe it makes sense to use the T-bill rate in these calculations. The basis for the Sharpe ratio and the linear relationship between risk and return is that you can turn a low-risk, low-return investment into a high-risk, high-return investment with leverage. However, you can't borrow at the T-bill rate. Also, maintaining the optimum amount of leverage requires trading which has the cost of commissions and spreads. My guess is that it would be more appropriate to use 5% or 6% in these calculations. I don’t believe it makes sense to use the T-bill rate in these calculations. The basis for the Sharpe ratio and the linear relationship between risk and return is that you can turn a low-risk, low-return investment into a high-risk, high-return investment with leverage. However, you can’t borrow at the T-bill rate. Also, maintaining the optimum amount of leverage requires trading which has the cost of commissions and spreads. My guess is that it would be more appropriate to use 5% or 6% in these calculations.

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