The capital asset pricing model (CAPM, pronounced as “cap-m”) was developed in 1952 by Harry Markowitz. It was later adapted by other economists and investors, including William Sharpe. CAPM describes the relationship between an investor’s risk and the expected return. It is designed to help model the pricing of higher-risk securities.

According to the CAPM theory, the expected return of a particular security or a portfolio is equal to the rate on a risk-free security plus a risk premium. If the security or portfolio does not either meet or exceed the required return, then the investment should not be entered into.

CAPM can be summarized according to the following formula:

Required (or expected) Return = RF Rate + (Market Return – RF Rate)*Beta

There are a number of important terms in the equation listed above. In order to properly understand it, let’s look to an example. Say that the current risk-free rate is 5%, and the S&P 500 is expected to bring in returns of 12% over the next year. You are interested in evaluating whether the return that Joe’s Oyster Bar, Inc. (JOB) will have over the same time period. You have determined that the stock’s beta value is 1.9, and the overall stock market has a beta of 1.0. This means that JOB carries a higher level of risk than the overall risk. Because of this extra risk, we should expect a higher potential return than the market’s 12% anticipated return. We can calculate the expected return of JOB as follows:

Required (or expected) Return =                  5% + (12%-5%)*1.9

Required (or expected) Return =                  18.3%

CAPM tells us that Joe’s Oyster Bar has a required rate of return of 18.3%. An investor who buys JOB stock should be getting at least 18.3% returns on his or her investment. If you have reason to believe that JOB will not be able to produce those returns for you over the specified time period, then it’s best to invest your funds elsewhere.

One important add-on to the CAPM theory is that high-beta shares typically provide the highest returns. Over a longer period of time, though, high-beta shares tend to be the worst performers during bear markets. Thus, while you may receive high returns from high-beta shares in a given window of time, there is no guarantee that the CAPM return will be realized.

Financial Concepts: Conclusion
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