Will Kenton is an expert on the economy and investing laws and regulations. He previously held senior editorial roles at 6294.org and Kapitall Wire and holds a MA in Economics from The New School for Social Research and Doctor of Philosophy in English literature from NYU." data-inline-tooltip="true">Will Kenton
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The CAPM and SML make a connection between a stock’s beta and its expected risk. A higher beta means more risk but a portfolio of high beta stocks could exist somewhere on the CML where the trade-off is acceptable, if not the theoretical ideal.

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The value of these two models is diminished by assumptions about beta and market participants that aren’t true in the real markets. For example, beta does not account for the relative riskiness of a stock that is more volatile than the market with a high frequency of downside shocks compared to another stock with an equally high beta that does not experience the same kind of price movements to the downside.


Practical Value of the CAPM

Considering the critiques of the CAPM and the assumptions behind its use in portfolio construction, it might be difficult to see how it could be useful. However, using the CAPM as a tool to evaluate the reasonableness of future expectations or to conduct comparisons can still have some value.


Imagine an advisor who has proposed adding a stock to a portfolio with a $100 share price. The advisor uses the CAPM to justify the price with a discount rate of 13%. The advisor’s investment manager can take this information and compare it to the company’s past performance and its peers to see if a 13% return is a reasonable expectation.


Assume in this example that the peer group’s performance over the last few years was a little better than 10% while this stock had consistently underperformed with 9% returns. The investment manager shouldn’t take the advisor’s recommendation without some justification for the increased expected return.


An investor can also use the concepts from the CAPM and efficient frontier to evaluate their portfolio or individual stock performance compared to the rest of the market. For example, assume that an investor’s portfolio has returned 10% per year for the last three years with a standard deviation of returns (risk) of 10%. However, the market averages have returned 10% for the last three years with a risk of 8%.


The investor could use this observation to reevaluate how their portfolio is constructed and which holdings may not be on the SML. This could explain why the investor’s portfolio is to the right of the CML. If the holdings that are either dragging on returns or have increased the portfolio’s risk disproportionately can be identified, the investor can make changes to improve returns.

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The Bottom Line

The CAPM uses the principles of Modern Portfolio Theory to determine if a security is fairly valued. It relies on assumptions about investor behaviors, risk and return distributions, and market fundamentals that don’t match reality. However, the underlying concepts of CAPM and the associated efficient frontier can help investors understand the relationship between expected risk and reward as they make better decisions about adding securities to a portfolio.