Why CAPM is (Still) Important
If you’ve ever tried to evaluate an investment, you know how frustrating it can be to balance risk and return. How many times have you asked yourself, “Is this stock really worth the risk I’m taking?” Or, “How do I compare a volatile tech stock with a government bond?”
The Capital Asset Pricing Model (CAPM), developed in the 1960s by William Sharpe, John Lintner, and Jan Mossin, was created precisely to answer these questions. It’s not just a theoretical model from a university textbook; it’s a tool that greatly simplifies the investment decision-making process.
Its beauty lies in offering a logical and quantifiable bridge between the risk of an investment and its expected return, eliminating the need for detailed estimates for each individual stock.
CAPM, in fact, identifies the efficient portfolio as the so-called “market portfolio,” a theoretical concept that represents the entirety of available financial instruments, weighted by their market capitalization.
This innovative perspective, in addition to reducing the complexity of calculations, also offers a more intuitive and structured approach to risk management and investment diversification.
In this first article, we will explore the foundations of CAPM: from the theoretical assumptions on which it is based to the crucial distinction between systematic and specific risk.
The Fundamental Assumptions of CAPM
Like every self-respecting economic model, CAPM is based on some theoretical assumptions that simplify reality. Milton Friedman clearly stated: the more significant a theory, the more unrealistic its assumptions will be.
Here are the main assumptions of CAPM:
Investors are rational and risk-averse — they maximize expected return for a given level of risk.
Markets are efficient — all relevant information is already incorporated into prices.
There are no transaction costs or taxes — you can buy and sell freely.
Investors can borrow and lend at the risk-free rate — there is a risk-free rate accessible to everyone.
Investors have the same time horizon — everyone reasons over a single period.
Expectations are homogeneous — all investors have the same forecasts on returns and risks.
These assumptions are clearly simplified compared to the reality of the markets, but they allow the model to function elegantly and provide practical insights. Don’t forget: a model doesn’t have to be perfect; it has to be useful.
The Market Portfolio and the Capital Market Line (CML)
At the heart of CAPM is the concept of the market portfolio. This theoretical portfolio contains all available risky assets, weighted by their market capitalization. In practice, it is often approximated with market indices such as the S&P 500 or the MSCI World.
The Capital Market Line (CML) graphically represents the relationship between expected return and risk (measured as standard deviation) for efficient portfolios. It starts from the risk-free rate (the intercept) and passes through the market portfolio.
The formula for the CML is:
E(Rp) = Rf + [(E(Rm) - Rf) / σm] × σp
Where:
E(Rp) = expected portfolio return
Rf = risk-free rate
E(Rm) = expected market return
σm = market standard deviation
σp = portfolio standard deviation
In practice, the CML tells you: if you want more return, you must accept more risk. But not just any risk: only market risk, the one you can’t eliminate with diversification.
Systematic Risk vs. Specific Risk
One of CAPM’s most important contributions is the distinction between two types of risk:
Specific Risk (or Idiosyncratic)
This is the risk associated with a single stock or sector. Examples:
A CEO who resigns suddenly
A product recall
A lawsuit against the company
This risk can be eliminated through diversification. If you have 30-40 well-distributed stocks, the specific risk tends to zero.
Systematic Risk (or Market Risk)
This is the risk that affects the entire market. Examples:
An economic recession
An increase in interest rates
A geopolitical crisis
This risk cannot be diversified away. It’s the risk that remains even if you own the entire market.
CAPM focuses exclusively on systematic risk because it is the only one for which investors should be rewarded. Specific risk, being eliminable, should not generate extra return.
The Foundations are Solid
CAPM starts from simplified assumptions but offers a powerful framework for thinking about investments. It teaches us that:
Not all risk is equal — only systematic risk really counts.
Diversification is key — it eliminates specific risk at no cost.
The market is the benchmark — the market portfolio is the reference point for every rational investor.
In the next article, we will enter the operational heart of CAPM: beta and the Security Market Line (SML), the tools that translate these concepts into concrete investment decisions.