ForecastingStocks

The Capital Asset Pricing Model (CAPM), developed by Sharpe, Lintner and others in the 1960s, answers a deceptively simple question: what return should an asset offer, given its risk?

The core idea

CAPM says investors should only be paid for risk they cannot diversify away. You can erase an individual company's idiosyncratic risk by holding many stocks, so the market will not reward you for it. The only risk left to compensate is systematic risk — sensitivity to the overall market, measured by beta.

The formula

expected return = risk-free rate
                + beta times (market return minus risk-free rate)

The term (market return minus risk-free rate) is the equity risk premium — the extra return the market as a whole pays for bearing market risk. An asset earns that premium scaled by its beta.

A worked example

Risk-free rate = 3 percent
Expected market return = 9 percent
Stock beta = 1.3
    expected return = 3 + 1.3 times (9 - 3) = 10.8 percent

So this stock should offer about 10.8 percent to justify its market risk. If you believe it will actually return more, it looks undervalued; less, overvalued. This is how CAPM becomes a tool for judging whether an asset's price is fair.

Why it matters beyond pricing

CAPM also underpins much of the performance math you just learned: alpha is literally the gap between an asset's realized return and its CAPM-predicted return. So CAPM is both a pricing model and the yardstick against which skill is measured.

The reality check

Decades of testing show CAPM is, at best, a rough approximation. Low-beta stocks have historically returned more than CAPM predicts and high-beta stocks less; size, value and momentum effects all earn returns CAPM cannot explain. It survives because it is simple, intuitive and a useful baseline — not because the world obeys it.