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Capital Asset Pricing Model

Although at first glance it looks likes a simple formula, the capital asset pricing model (CAPM) represents an historic effort to understand and quantify something that’s not at all simple: risk. Conceived by Nobel economist William Sharpe in 1964, CAPM has been praised, appraised, and assailed by economists ever since.

What It Measures

The relationship between the risk and expected return of a security or stock portfolio.

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Why It Is Important

The capital asset pricing model’s importance is twofold.

First, it serves as a model for pricing the risk in all securities, and thus helps investors evaluate and measure portfolio risk and the returns they can anticipate for taking such risks.

Second, the theory behind the formula also has fueled—some might say provoked—spirited debate among economists about the nature of investment risk itself. The CAPM attempts to describe how the market values investments with expected returns.

The CAPM theory classifies risk as being either diversifiable, which can be avoided by sound investing, or systematic, that is, not diversified and unavoidable due to the nature of the market itself. The theory contends that investors are rewarded only for assuming systematic risk, because they can mitigate diversifiable risk by building a portfolio of both risky stocks and sound ones.

One analysis has characterized the CAPM as “a theory of equilibrium” that links higher expected returns in strong markets with the greater risk of suffering heavy losses in weak markets; otherwise, no one would invest in high-risk stocks.

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How It Works in Practice

CAPM holds that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat a theoretical required return, the investment should not be undertaken. The formula used to create CAPM is:

Expected return = Risk-free rate + (Market return − Risk-free rate) × Beta value

The risk-free rate is the quoted rate on an asset that has virtually no risk. In practice, it is the rate quoted for 90-day US Treasury bills. The market return is the percentage return expected of the overall market, typically a published index such as Standard & Poor’s. The beta value is a figure that measures the volatility of a security or portfolio of securities compared with the market as a whole. A beta of 1, for example, indicates that a security’s price will move with the market. A beta greater than 1 indicates higher volatility, while a beta less than 1 indicates less volatility.

Say, for instance, that the current risk-free rate is 4%, and the S&P 500 index is expected to return 11% next year. An investment club is interested in determining next year’s return for XYZ Software Inc., a prospective investment. The club has determined that the company’s beta value is 1.8. The overall stock market always has a beta of 1, so XYZ Software’s beta of 1.8 signals that it is a riskier investment than the overall market represents. This added risk means that the club should expect a higher rate of return than the 11% for the S&P 500. The CAPM calculation, then, would be:

4% + (11% − 4%) × 1.8 = 16.6%

What the results tell the club is that given the risk, XYZ Software Inc. has a required rate of return of 16.6%, or the minimum return that an investment in XYZ should generate. If the investment club doesn’t think that XYZ will produce that kind of return, it should probably consider investing in a different company.

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Tricks of the Trade

  • As experts warn, CAPM is only a simple calculation built on historical data of market and stock prices. It does not express anything about the company whose stock is being analyzed. For example, renowned investor Warren Buffett has pointed out that if a company making Barbie™ dolls has the same beta as one making pet rocks, CAPM holds that one investment is as good as the other. Clearly, this is a risky tenet.

  • While high returns might be received from stocks with high beta shares, there is no guarantee that their respective CAPM return will be realized (a reason why beta is defined as a “measure of risk” rather than an “indication of high return”).

  • The beta parameter itself is historical data and may not reflect future results. The data for beta values are typically gathered over several years, and experts recommend that only long-term investors should rely on the CAPM formula.

  • Over longer periods of time, high-beta shares tend to be the worst performers during market declines.

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Further reading on Capital Asset Pricing Model



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