Why CAPM is still used to link risk and return

How much return should you expect for taking extra risk? The capital asset pricing model, or CAPM, gives a simple answer. This page explains the idea behind CAPM, its formula, a worked example and why it is both popular and criticised.

Quick answer

CAPM, the capital asset pricing model, says that the expected return on a share equals the risk-free rate plus its beta multiplied by the market risk premium. Beta measures how much the share tends to move with the overall market. The model suggests investors are rewarded only for market-wide risk that cannot be removed by diversification, not for company-specific risk.

Key takeaways

• It links expected return to market risk.
• Formula: risk-free rate + beta x market risk premium.
• Beta measures sensitivity to market moves.
• Only non-diversifiable risk is rewarded in the model.
• It is widely used, but real data does not always fit it.

What is CAPM?

The model was developed in the 1960s by William Sharpe, along with John Lintner, Jan Mossin and Jack Treynor. Sharpe shared the 1990 Nobel Prize in economics, partly for this work. It built on Harry Markowitz's ideas about diversification.

Its main idea is that risk comes in two parts. Company-specific risk, like a factory fire, can be reduced by holding many shares. Market risk, like a recession, affects almost all shares and cannot be diversified away. CAPM says only market risk earns extra return.

The CAPM formula

Expected return = Risk-free rate + Beta x (Market return minus Risk-free rate). The part in brackets is the market risk premium, the extra return investors expect from the market over a safe asset.

A share with beta above 1 tends to move more than the market, so the model expects a higher return. A beta below 1 means smaller moves and a lower expected return. These numbers are only for illustration.

How is CAPM used?

Its most common use is to estimate the cost of equity, which then feeds into WACC and discounted cash flow valuation. Fund managers also use it to judge performance: a return above what the model predicts for the fund's beta is called alpha.

It also gives a simple way to compare the expected return of shares with different risk levels on one scale.

What are the limits of CAPM?

The model rests on strong assumptions, such as all investors having the same information and being able to borrow at the risk-free rate. Studies, including work by Fama and French, found that beta alone does not fully explain differences in returns, which led to multi-factor models.

Inputs are also hard to pin down. Beta changes over time, and the market risk premium is an estimate. Even so, the model remains a common starting point because it is simple and easy to explain.

The key point to remember

The model says expected return rises with market risk measured by beta. It is a useful framework for thinking about risk and return, not a forecast of what any share will actually earn.

Frequently Asked Questions