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The capital asset pricing model (CAPM) is a mathematical formula that calculates an investmentâs expected return based on its exposure to market risk. It starts with a risk-free rate of return and adds a risk premium adjusted for the investmentâs beta, which measures its sensitivity to market movements. Developed by William F. Sharpe in 1964, CAPM remains a widely used framework for evaluating risk and return.
What is the difference between systematic and unsystematic risk in CAPM?
Systematic risk, also called market risk, affects investments across the economy and cannot be eliminated through diversification. Unsystematic risk, or company-specific risk, includes events such as disappointing earnings, failed products, or management problems. Diversification can reduce unsystematic risk, so CAPM assumes investors are compensated for taking systematic risk rather than risks they can diversify away.
What are the limitations of the capital asset pricing model?
CAPM assumes investors can borrow and lend at the risk-free rate, even though borrowing typically costs more. It also uses beta as its sole measure of market risk, overlooking other factors that influence stock returns, such as company size and valuation. Finally, the market risk premium changes over time, making expected returns difficult to estimate precisely.
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If you invest using index funds, youâre already tapped into CAPM.
EncyclopĂŠdia Britannica, Inc.
For decades, investors looked at each investment opportunity as an independent entity. They analyzed companies on their own merits, not thinking about how each interacted with the financial system.
Then, in 1964, William F. Sharpe introduced the capital asset pricing model (CAPM). Rather than worry about the unique things that affected each company, Sharpe claimed that they canceled out in a diversified portfolio. The only risk investors were compensated for taking was their exposure to the overall market.
Key Points
The capital asset pricing model (CAPM) revolutionized finance by simplifying the analysis of risk and return.
According to the CAPM formula, the return on an investment is equal to the risk-free rate plus the risk premium associated with that investment.
The model is one of the drivers of index investing, which has become popular for offering competitive returns at a very low cost.
The capital asset pricing model itself is a mathematical formula. It has been refined over the years, but the basic concept still holds. It upended Wall Street and earned Sharpe a Nobel Prize in 1990. (The CAPM is also a legacy of modern portfolio theory, developed by economics professor Harry M. Markowitz in 1952.)
The basics of the capital asset pricing model
Sharpeâs paper, âCapital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk,â was published in The Journal of Finance in September 1964. It said that stock market returns are a function of market riskânothing else. The CAPM equation is:
R = rf + B ( rm â rf )
Where:
R="Expected" return on the asset
rf = The risk-free rate of return
B = The sensitivity of the assetâs performance to the return of the market, also known as beta
( rm â rf ) = The average return on the market less the risk-free rate of return, also known as the risk premium
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Figure 1: MANY HAPPY RETURNS ⊠ADJUSTED FOR RISK. The capital asset pricing model explains how the market pricing of risky assets enables them to fit into an investorâs portfolio because they can be combined with less risky investments.
EncyclopĂŠdia Britannica, Inc.
On the graph, rf is the intercept because you can receive that return without taking any risk. The slope of the line is the market risk premium, while beta measures the stockâs sensitivity to market movements.
How risks cancel out
Sharpe said that public companies face two types of risk. The first is idiosyncratic risk, also known as unique risk or unsystematic risk. This risk is specific to each company. For example, will customers like a new product line? Will the company be able to pass on price increases? What if an executive commits fraud? In a diversified portfolio, Sharpe said, these risks cancel out.
That leaves the other risk: systematic risk, which is also called market risk. This is the risk of being in the financial system, and all companies are exposed to it. For example, if the Federal Reserve adjusts interest rates, all companies are affected in different ways. If the entire market crashes, as it did in 2008, every stock goes down regardless of individual performance.
Because idiosyncratic risks cancel out with diversification, Sharpe said that investors donât receive compensation for taking them. They receive compensation only for the risk of being in the market in the first place.
Using the CAPM
The capital asset pricing model assumes that investors have two assets available for investment: the risk-free asset and the market portfolio. If you want the same risk as the market, you buy the market portfolio, which would be an index fund.
If you want less risk, you can reduce it by buying Treasury securities, which means youâre essentially lending money to the government at a risk-free rate of return (although, technically, no investment is totally risk-free). If you want more riskâand more returnâthan the market portfolio (index fund), you can borrow money to increase your market exposure (that is, you can buy securities on margin through your brokerage firm). Investors can adjust their risks as their risk preferences change without investing in anything other than the market portfolio.
The CAPM and the real world
One of the greatest implications of the CAPM is that diversification can reduce company-specific risk without sacrificing expected returns. A portfolio representing the overall market offers broad exposure without requiring investors to select individual stocks. This finding was one of the drivers of index investing, which has become popular for offering competitive returns at a very low cost.
Still, the model has some problems.
Can you really borrow at the risk-free rate? Although brokers allow customers to borrow funds all the time, the rate is considerably higher than the risk-free rate that Sharpe used in his assumptions.
Is a single âmarket riskâ snapshot too simplistic? Several researchers have developed expanded versions of the CAPM that look at the size of the firm, price-to-book value, and other factors that may influence asset performance.
Is market risk premium fixed?Markets run in cycles, and so do expectations. According to data from S&P Global, the long-term average of the forward price-to-earnings ratio (forward P/E) on the benchmark S&P 500 (which, by definition, has a beta of 1.0), is about 15.5. But within the last 20 years, the forward P/E has been as high as 25 and as low as 11. Over longer stretches (including the dot-com bubble and the Great Depression), the numbers would be even more dispersed. These changing valuations reflect shifts in investor expectations, including the returns they demand for taking risk. In other words, the market risk premium isnât fixed.
The bottom line
Researchers continue to explore ways to improve and modify the CAPM, but the popularity of index funds shows that the average investor agrees with Sharpe whether they realize it or not. The simple structure of the CAPM allows fund managers and researchers to experiment and find their edge, keeping the model in the financial conversation.
