As seen previously, adjusting for the risk of an asset using the risk-free rate, an investor can easily alter his risk profile. Keeping that in mind, in the context of the capital market line (CML), the market portfolio consists of the combination of all risky assets and the risk-free asset, using market value of the assets to determine the weights. The CML line is derived by the CAPM, solving for expected return at various levels of risk.

Markowitz' idea of the efficient frontier, however, did not take into account the risk-free asset. The CML does and, as such, the frontier is extended to the risk-free rate as illustrated below:



Systematic and Unsystematic Risk
Total risk to a stock not only is a function of the risk inherent within the stock itself, but is also a function of the risk in the overall market. Systematic risk is the risk associated with the market. When analyzing the risk of an investment, the systematic risk is the risk that cannot be diversified away.

Unsystematic riskis the risk inherent to a stock. This risk is the aspect of total risk that can be diversified away when building a portfolio.


Formula 17.10

Total risk = Systematic risk + Unsystematic risk




When building a portfolio, a key concept is to gain the greatest return with the least amount of risk. However, it is important to note, that additional return is not guaranteed for an increased level of risk. With risk, reward can come, but losses can be magnified as well.



The Capital Asset Pricing Model (CAPM)

Related Articles
  1. Investing

    Explaining the Capital Market Line

    The capital market line (CML) depicts the level of additional return above the risk-free rate for each change in the level of risk.
  2. Investing

    The Capital Asset Pricing Model: An Overview

    CAPM helps you determine what return you deserve for putting your money at risk.
  3. Managing Wealth

    Modern Portfolio Theory: Why It's Still Hip

    See why investors today still follow this old set of principles that reduce risk and increase returns through diversification.
  4. Investing

    Risk-Free Rate of Return

    The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free ...
  5. Investing

    How Risk Free Is The Risk-Free Rate Of Return?

    This rate is rarely questioned - unless the economy falls into disarray.
  6. Personal Finance

    Risk Management Framework (RMF): An Overview

    A company must identify the type of risks it is taking, as well as measure, report on, and set systems in place to manage and limit, those risks.
  7. Managing Wealth

    One Portfolio For Asset Allocation

    If you treat all of your investments as a single portfolio, you will be better able to maximize returns.
  8. Investing

    Diversification Beyond Stocks

    If you think holding several stocks means you're diversified, think again - there's much more to be done to reduce portfolio risk.
  9. Investing

    Is Apple's Stock Over Valued Or Undervalued?

    Despite several drawbacks, the CAPM gives an overview of the level of return that investors should expect for bearing only systematic risk. Applying Apple, we get annual expected return of about ...
  10. Financial Advisor

    Active Risk vs. Residual Risk: Differences and Examples

    Active risk and residual risk are common risk measurements in portfolio management. This article discusses them, their calculations and their main differences.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center