The Capital Assett Pricing Model (AKA How to Choose an Investment)

I have been in the teaching business for many years, and one of the hobbies I acquired during that time is making a complicated subject simple enough that almost anyone could understand it.

Today, I am talking about the Capital Asset Pricing Model.... and by the end of this post, you will probably be able to understand it.... (I hope)

But why do you care?
Good question.

If you plan on making any investments during your lifetime (including buying a home), a familiarity with this topic will likely greatly help you make your investment decision.

So...buckle up, here we go.


The Capital Asset Pricing Model, or CAPM (pronounced "kap-em") is a visual tool that helps show how the rewards from making an investment are usually connected to the risk of that investment.

Here is a CAPM chart. On the vertical (or Y) axis, you can see the annual returns (aka income or growth) of an investment, and along the bottom (X axis) you can see the riskiness of that investment.The red line is called the Security Market Line and the dots on it represent investment choices.

Now, lets look at the where the red line is touching the Y axis (far left). You can see that the return of that investment choice is 2%, while the risk is 0. This is what we call the "Risk Free Rate" (or RFR). This is the amount you could make on your money without taking on any risk at all.  Examples of investments of this type would be your bank account, government savings bonds, etc.

But let's say that you were not happy with getting only 2% return on your investment. Let's say that you wanted to make more.You could invest your money in something that averages around 8% per year (which sounds much better than 2%), but hold on....it's more risky. You would expect, no wait, demand higher returns on investments that were more risky. So the additional return is a lot like compensation for taking on more risk (meaning more wild swings in returns and a higher chance of losing your investment).

So, the 8% choice is more risky... but how risky is it?

Well, here is how risk is measured. Do you see the 1.0 that is directly under the 8% investment dot? And do you see the Beta β as well? Beta is the term that financial people use to represent riskiness. A Beta of 0 means that the investment has absolutely no risk (your investment and the returns are absolutely certain to come back to you). A Beta of 1.0 however is average riskiness (when you take the whole economy into account) and a Beta of 2.0 would mean that the investment is twice as risky as average (like a tech stock).

So if you hate risk, you can invest your money at 2% (or whatever the current RFR is), but if you are willing to take on more risk than the average investment has in order to get higher rewards, then you could invest your money into something that had a Beta of 2.0 or even 3.0.

So, the first lesson to remember is that if someone (like a financial adviser) tries to get you to invest in something that has high returns, check to see if the risk is high too..... (it probably is)

So, how do you compare an investment that has a return of 6% and 12%? Wouldn't you say that the higher return option is better?

Well, not so fast.
If you look on the chart, you can see that the 6% option has a Beta of 0.75 and the 12% option has a Beta of 1.5. In financial terms, we would say the the two investments have equal value. One has lower returns and risk and one has higher returns and risk. You may have a preference for one over the other, but they are basically the same.

Now, let's complicate things a bit.

Do you notice that there are dots (investment choices) all over the chart?
This is how the world of investments actually works.

Although you would expect that returns and risk would all sit right on the line, this is not how it always happens. Sometimes you will see investment choices that are above the line (the reward is higher than the risk would suggest) while at other times you see choices that are below it (meaning that the returns are lower than you would expect, given the riskiness)

If an investment provides greater returns than its risk level would indicate, we would say that this investment has "outperformed the market" (and you as the investor would be happy). If the opposite is true, then we would say that the investment had "underperformed". Obviously, investors are looking for the former and trying to avoid the latter.

Any time you are making an investment decision, you should consider not just the potential payoff of your choice, but the possible risks as well. Many investors have chosen investment options that advertised high returns, but have done so without considering the riskiness of those options. This often results in unexpected swings in returns, and many sleepless nights.

So, in conclusion, before investing your money, try to compare both the reward and the risk of your choices. Look for choices that will likely outperform the market, but only at a level of risk which would allow you to sleep at night.