Introduction

One of my firm beliefs is that investors looking to reduce their investment mistakes should start by understanding the CAPM model. It is a fundamental economic model which has shaped many aspects of modern investment theory, including the efficient market hypothesis. Fully understanding the Capital Asset Pricing Model (CAPM) and its consequences will help you make better decisions. Let’s dive in.

The Basics of CAPM

The Capital Asset Pricing Model (CAPM) is a framework that quantifies the relationship between the expected return of an investment and its risk, particularly in the context of a diversified portfolio. It was developed in the 1960s by William Sharpe, John Lintner, and Jan Mossin, and since then, it has become a cornerstone of modern finance.

At the heart of CAPM lies the notion that investors require two key things from their investments: compensation for the time value of money (risk-free rate) and an additional premium for taking on the extra risk associated with an investment (market risk premium). The simplified formula for CAPM is as follows:

Expected return = risk-free rate + Beta * market risk premium

The stock's Beta measures its sensitivity to market movements. The average beta of all stocks is 1. A beta of 1.5 means that when the overall stock market appreciates by 10%, the given stock appreciates by 15%. Typically, tech companies have high betas, utility stocks have low betas.

Making fewer mistakes, thanks to CAPM

CAPM underscores the fundamental concept that there is a direct relationship between risk and return. Investments for which you can expect higher returns bear greater risks. Budding tech companies have a higher potential for 10x returns than a utility company, but also a higher potential to go bust.

The CAPM model is closely linked with the Efficient Markets Theory (EMT). EMT posits that all available information is already reflected in stock prices, making it impossible to consistently achieve returns above the market average through active trading or stock picking. As a result, the CAPM and EMT framework dictate that consistently earning abnormal risk-adjusted returns is not possible.

Conclusion

The Capital Asset Pricing Model (CAPM) is essential to understand the relationship between risk and return. The CAPM framework, closely tied to Efficient Markets Theory (EMT), can help you avoid common investor pitfalls. The key lesson is that, in efficient markets, higher expected return comes with higher expected risk.

The CAPM and EMT framework are both imperfect frameworks to understand the stock market. However, for the average investor, your investment results will be much better if you invest as if these frameworks are perfect, i.e. all stocks are always priced as per CAPM. By investing as if markets are perfectly efficient, you will likely do better than the investor who is always looking for the ‘perfect’ trade. When you believe you have spotted a ‘sure’ way to earn a high return with no risk, it is more likely that you are wrong, than that such opportunity exists.

By applying the principles of the CAPM framework, we realize that “sure” investments which yield high returns cannot exist. The most important conclusion of the CAPM is this: when somebody offers you an investment with an expected return much higher than the risk-free rate, the investment carries significant risk, no matter what they say.