AN MIT PROFESSOR named Edward Lorenz published a paper in 1972 titled Predictability: Does the Flap of a Butterfly’s Wings in Brazil Set off a Tornado in Texas?
It was a catchy title. Though Lorenz didn’t mean it literally, the basic idea was that events in the physical world are highly interconnected—more so than they might appear.
The world of investments is similarly interconnected in ways that aren’t always visible. Just like the weather, investment markets may appear random on the surface, but there is an underlying cause-and-effect logic that drives much of what we see. In finance, the equivalent of Lorenz’s butterfly effect is a notion called the Capital Market Line. The name isn’t as catchy, but the idea is very similar.
The premise of the Capital Market Line is that all investments can be mapped on a continuum. The line starts with government bonds—known as the “risk-free asset”—and then extends to riskier assets, including stocks. Investments further out on the line offer greater return potential but also greater risk. In other words, there’s a tradeoff between risk and return. That’s a well understood concept in finance.
Here’s what’s more interesting about the Capital Market Line: It isn’t simply a menu of independent investment choices. In reality, all the points on the line are interconnected. Specifically, each investment on the line affects its closest neighbors, and they, in turn, affect their closest neighbors. As a result, when the risk or return characteristics of one investment change, that indirectly affects every other investment up and down the line. To visualize this, imagine a crowded subway car. When one person moves, that affects the next person, and the next person, and so on.
The Capital Market Line is worth understanding because it explains so much of what we see in the investment world, and that can help each of us in making decisions with our own portfolio.
In Europe today, you can see the Capital Market Line at work. Because of weak economic growth, the European Central Bank has pushed interest rates below zero. As a result, many banks are no longer paying interest to customers. Instead, accountholders have to pay banks to hold their money. It’s completely upside down. A recent Wall Street Journal article described the result: Frustrated savers have been taking money out of the bank and investing it elsewhere.
The article highlighted a 70-year-old German man named Michael Schacht. “I don’t want to make lots of money,” he said. “I just want a low-risk investment that provides a reasonable return on capital, like 2%, 4%.” But because his bank couldn’t come close to that modest goal, he withdrew his entire balance and opened a brokerage account to buy stocks, bonds and commodities—anything to try to eke out a positive return. He’s not alone. In Germany, the number of brokerage accounts has increased 28% since 2019.
Schacht’s plight is a perfect illustration of the Capital Market Line. When the European Central Bank dropped its interest rate, commercial banks dropped theirs. That prompted millions of new investors to pile into the stock market, and those new investors drove up stock prices to all-time highs.
We’ve seen much the same thing recently in the U.S. Banks are still paying positive interest rates here—thankfully—but bond rates are very low, less than 1% in some cases. The result: Many investors here are making the same choice as folks in Germany. With bond yields so meager, it becomes more and more tempting to take our chances in the stock market, despite the increased risk. Each time another investor decamps from bonds to stocks, it helps push stocks a little higher—like that extra person squeezing himself through the subway doors, forcing everyone else to take a step back.
So far, we’ve been looking at the tradeoffs among cash, bonds and stocks. But those aren’t the only choices. Changes to any investment along the Capital Market Line also cause some investors to search for non-traditional assets. This helps explain the acceleration in home prices over the past year, as well as the sharp rise in cryptocurrencies. Public company stock prices also affect private company valuations, which have seen a similar run-up. In other words, because bond yields are so low, the prices of virtually every other asset have climbed, thus increasing their risk and lowering their prospective returns.
The impact of the Capital Market Line reaches into the furthest corners of the investment world. For example, the recent surge in new special purpose acquisition companies (SPACs) has resulted in a bonanza for holders of many junk bonds. Those two investments might seem unrelated, but here’s the connection: When a SPAC purchases a heavily indebted company, it often triggers a requirement that the company buy back its outstanding debt. This provides a windfall to its bondholders. This is an obscure phenomenon, but it further illustrates the dynamics of the Capital Market Line.
Being an investor at a time like this can feel like an exercise in frustration. Everything seems expensive. That’s why I believe it’s so important to understand the Capital Market Line. It helps explain why we’re seeing what we’re seeing, and it helps explain the truth behind the old cliché that “there’s no such thing as a free lunch.” Ultimately, that’s the most important lesson of the Capital Market Line. Many investors have been searching high and low for better deals than those offered by standard investments. Some might exist. But more often than not, the most fundamental principle in finance still holds: If something promises higher returns, it must involve higher risk—and that higher risk could come back to haunt investors.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, he advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman and check out his earlier articles.