Every investor wants to answer one key question: “Am I getting compensated fairly for the risk I’m taking?” That’s exactly what CAPM (Capital Asset Pricing Model) helps you figure out.

Used widely in valuation, investment decisions, and portfolio management, CAPM is one of the most important models in finance—and yet, often misunderstood. Let’s break it down:

💡 What is CAPM?

CAPM helps calculate the expected return on an investment based on its systematic risk—that is, risk relative to the overall market.

🔹 CAPM Formula: Ra = Rf + [β × (Rm – Rf)] Where:

  • Ra – Expected return of the asset
  • Rf – Risk-free rate
  • β – Beta (systematic risk)
  • Rm – Expected market return
  • (Rm – Rf) – Market risk premium

🔍 Key Terms You Need to Know:

✅ Efficient Frontier: A visual curve showing the best combinations of return vs. risk. It helps identify the optimal portfolio mix.

✅ Market Portfolio: A theoretical portfolio holding all investable assets, weighted by market value. It lies on the efficient frontier and represents ideal diversification.

✅ Risk-Free Rate (Rf): Return on a no-risk investment, like a government bond.

✅ Beta (β): A measure of volatility:

  • β > 1: More volatile than the market
  • β < 1: Less volatile
  • β = 1: Moves with the market

✅ Market Risk Premium (Rm – Rf) The additional return investors demand for taking on market risk.

🔧 Practical Applications of CAPM

📌 1. Portfolio Diversification Use CAPM to estimate the required return and spread investments accordingly to reduce unsystematic risk.

📌 2. Investment Evaluation: Compare the CAPM expected return to projected returns—if the investment underperforms the model, it’s likely overvalued.

📌 3. Performance Measuremen:t Evaluate fund managers or investment portfolios by comparing actual vs. CAPM-expected returns.

⚠️ Limitations to Keep in Mind

🧩 Real markets aren’t perfectly efficient

🧩 Beta changes over time

🧩 Assumes a single investment period

🧩 Ignores taxes, transaction costs, and behavioral biases

CAPM isn’t flawless, but it’s a foundational model for estimating required return and assessing fairness of pricing. Combine it with other tools (like DCF and IRR) for deeper analysis.

If you want to download the infographic or use the template, check it out below:

👉 ​​Download CAPM PDF

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