the Capital Asset Pricing Model (CAPM) says

Ever wondered why some investments seem riskier than others?

Imagine you're planning a road trip with friends and need to decide between a scenic route and a direct highway. The scenic route is longer and more unpredictable, while the highway is shorter and more reliable.

The scenic route (high-risk investment) might be more rewarding but comes with uncertainties. The highway (low-risk investment) offers a predictable journey. The capital asset pricing model (CAPM) helps investors figure out how much extra reward they should expect for taking on more risk.

Example

If the scenic route (high-risk) promises a 20% reward for the extra risk, and the highway (low-risk) offers a 5% reward, investors can use CAPM to decide if the higher reward is worth the uncertainty.

Remember this

CAPM helps you balance the extra reward for taking on more risk.

Text adapted from Wikipedia, licensed under CC BY-SA 4.0.

Related concepts

Risk premium

Why do some investments pay more than others?

Beta (finance)

Beta measures a stock's volatility relative to the market

Fama–French three-factor model

Fama-French model adds size and value factors to CAPM

Modern portfolio theory

Modern Portfolio Theory (MPT) maximizes expected return for a given level of risk through diversification

Arbitrage pricing theory

APT uses multiple systematic risk factors; CAPM uses a single market index

Risk parity

Risk parity allocates based on risk contribution, not capital allocation

Educational content, not financial advice.

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