Definition of Capital Asset Pricing Model (CAPM): A formulae for investor expected return, which states that a return is a function of the risk-free rate, the market return for taking risk, and the extent to which an investor is exposed to that risk.
The capital asset pricing model formulae is as follows:
Capital Asset Pricing Model (CAPM)
Expected return on a risky asset = Risk-free expected return + market risk premium * Beta.
The risk-free expected return is the rate of return on an asset with a virtually guaranteed return, such as a triple A rated short term government bond. This return can be readily observed from the bond price, maturity date and coupon rate.
The market risk premium is the rate of return that the overall stock market provides to investors, above and beyond the risk-free return %. This premium can be calculated using historical data.
Beta is the extent to which a risky asset matches the volatility (or risk) of price movements in that overall stock market. See definition of beta for more details. Beta is expressed as a correlation coefficient where 1 means the asset is equally as volatile as the broader market, and 0.5 means the asset displays half the volatility.
What does the Capital Asset Pricing Model (CAPM) show us?
The CAPM formulae helps us to understand that:
a) Any asset, whether risky or not, will provide a baseline return equal to the risk free rate
b) Risky assets will provide a premium return, but only in proportion to the amount of market risk we take.
What we can deduce is that there is no free lunch in investing. If you find an asset with lower volatility, and therefore lower risk, then it is likely that you will receive a lower return.
This leads us to the conclusion that building an investment portfolio isn’t amount minimising risk – it’s about choosing the right level of risk that we are willing to take.
How is the phrase Capital Asset Pricing Model (CAPM) used in a sentence?
“If we take the relationship between risk and return per the capital asset pricing model as true, then we can appreciate that a risk-free portfolio will not produce an attractive return.”
What else you should know about the Capital Asset Pricing Model (CAPM)
The CAPM equation is only a basic principle and isn’t used by professionals to calculate the detailed expected return of each of the main asset classes. It’s unlikely that a financial adviser or stockbroker will take you through this theory as it simply isn’t practical to use.
It’s better seen as the illustration of an intuitive concept; that when we buy shares or invest in property, we will not be rewarded by the market for taking zero risk.
As property investment books and similar investment courses will explain; when you’re investing in shares or buying property investments, you need to be mindful of the maximum risk you want to take. The CAPM formula could lead some investors to seek out the maximum risk to maximise their returns, however, this path ends poorly.
Excessive risk-taking can lead to being wiped out and being made bankrupt. Even in better scenarios, it can create a stressful investing experience and greater financial uncertainty about the future. Don’t undervalue your mental health throughout your investing journey.
Risks should only be taken if they sit within your comfortable limits, and are necessary to achieve your target expected return.