Under Modern Portfolio Theory, a promising stock can add little value to a client's portfolio if its return does not justify its risk. A less exciting holding can improve the portfolio through diversification.
Before recommending an investment, you need a benchmark for deciding whether its potential reward justifies its risk. The Capital Asset Pricing Model (CAPM) estimates the return investors should require for bearing an investment's exposure to broad market movements.
Separate three numbers when using capital asset pricing. An expected return is your forecast based on possible future outcomes. A required return is the compensation demanded for taking risk. A realized return is what actually happens. Comparing expected with required return helps evaluate an investment before purchase; realized return arrives afterward.
The risk-free rate is the return available without uncertainty over the model's investment period. The market risk premium is the market portfolio's expected return minus that risk-free rate. It represents the additional expected reward for accepting market risk. These inputs must refer to the same investment period.
Common mistakes
- Multiplying the whole market return. With 4% risk-free return, 9% market return, and beta 1.2, the trap is 4% + 1.2 × 9% = 14.8%. CAPM requires 10%.
- Confusing the two graph axes. A standard deviation of 20% does not mean beta equals 0.20. Check the capital market line versus the security market line.
- Averaging individual volatilities. Two equally weighted assets with 20% volatility and zero correlation produce about 14.14% portfolio volatility, not 20%.
Bottom line
- CAPM required return equals the risk-free rate plus beta times the market risk premium.
- CAPM compensates systematic risk; its assumptions do not guarantee realized returns.
- Expected return above the security market line indicates undervaluation under CAPM; below it indicates overvaluation.
- Portfolio expected return is a weighted average, while risk also depends on individual volatility and correlations.
Exam shortcut
Underline whether the stem gives “market return” or “market risk premium.” Subtract the risk-free rate only when converting market return into the premium. Before choosing a graph, circle its horizontal-axis measure. Then check whether the question concerns an individual security or an efficient portfolio. For portfolio comparisons, first hold return constant and compare risk. If neither portfolio wins on that basis, check whether the question supplies a customer's risk preference.
The full lesson (about 3,523 words, 23 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- C11
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