What is the Capital Asset Pricing Model?

The Capital Asset Pricing Model (CAPM) is a tool used by finance professionals and portfolio managers to analyze potential investments for expected returns. It measures the relationship between risk and return, allowing investors to set expectations for their investments. CAPM was introduced in the early 1960s as a way to calculate expected returns based on risk, making it a breakthrough in financial theory.

How does the Capital Asset Pricing Model Work?

CAPM works by providing a formula for analysts to determine the expected returns of an asset. The formula is: Expected Return = Risk Free Rate + (Market Risk Premium x Beta). The risk-free rate is typically the U.S. Treasury rate, the market risk premium compensates for risk, and beta compares the asset's price changes to the market's price changes. By using this formula, investors can calculate the expected return of an asset and compare it to the actual return.

Pros and Cons of the Capital Asset Pricing Model

Pros of CAPM include its simplicity, focus on systematic risk, and ability to show the risk-return relationship. However, it only accounts for market risk and makes assumptions about investor behavior and capital markets. While it is a useful tool for portfolio managers, it should not be the sole basis for buy/sell decisions on individual securities.

What It Means to the Average Investor

For the average investor, CAPM and the Security Market Line can help understand the risk associated with different levels of return for their financial plan and investment strategy. While CAPM is widely used in the finance industry, it is important to remember its limitations and consider other factors when making investment decisions.