What is CAPM and how does it price risk?

In brief: The Capital Asset Pricing Model (CAPM) describes the relationship between risk and expected return. It says that the only risk you should be rewarded for is market risk (beta) — because all other risks can be diversified away. It's the most taught model in finance, used everywhere, and also widely criticised for being too simplistic.

CAPM was developed in the 1960s by William Sharpe (who won the Nobel Prize for it). Its central insight: in a well-functioning market, investors are only compensated for risks they cannot eliminate through diversification. If you hold 500 stocks, company-specific risks cancel out. What remains is market risk — and that's the only risk that commands a return premium.

The formula

  E(R) = Rf + β × (Rm − Rf)

Where: E(R) = expected return on the asset, Rf = risk-free rate, β = beta (market sensitivity), Rm − Rf = market risk premium (the extra return of stocks over cash).

The Security Market Line

CAPM produces a straight line — the Security Market Line (SML) — plotting expected return against beta. Every fairly-priced asset should sit on this line. If an asset sits above the line (higher return than beta predicts), it's undervalued. Below the line: overvalued.

CAPM in practice: the cost of equity

CAPM's most practical use is estimating the cost of equity for WACC calculations. If the risk-free rate is 4%, the market risk premium is 6%, and a company has beta of 1.3:

Cost of Equity = 4% + 1.3 × 6% = 11.8%

This gives the minimum return shareholders require to invest in this company rather than holding cash.

The critiques

CAPM assumes: all investors can borrow and lend at the risk-free rate, no taxes or transaction costs, all investors hold identical beliefs. None of these hold. Empirically, low-beta stocks have historically outperformed what CAPM predicts; high-beta stocks have underperformed. Fama and French added size and value factors to explain returns CAPM missed — and the model has been extended many times since. Yet CAPM remains the starting point because of its elegance and interpretability.

What this means for you

CAPM's core insight — that only non-diversifiable risk deserves compensation — is genuinely valuable, even if the formula itself is imperfect. It's why holding a concentrated portfolio in a few stocks is risky in a way that doesn't get rewarded: that specific risk could have been diversified away for free. The model also explains why "safe" utility stocks have low expected returns (low beta, low risk premium) and why small-cap tech stocks have high expected returns (high beta, high risk premium demanded).