CAPM Message to Corporations and Investors

Subject: Financial Management
Pages: 2
Words: 323
Reading time:
2 min

The capital asset pricing model has different messages to different people. To investors, the message is simply to invest in a large amount of stock to reduce the risk of losing your investment. An investor should invest in a well-diversified portfolio that is in some securities to make sure that his investment is safe. The investment portfolio should be reasonable to the market in which the investor has put his money. The Capital Asset Pricing Model is not the only model of risk and return. It captures only two fundamental ideas. First, almost everyone agrees that investors require some extra return for taking on risk. Second, investors appear to be concerned principally with the market risk that they cannot eliminate by diversification.

The basic idea behind the capital asset pricing model is that investors expect a reward for both waiting and worrying, the greater the worry, the greater the expected return. If you invest in a risk-free treasury bill, you just receive the rate of interest. That’s the reward for waiting. When you invest in risky stocks, you can expect an extra return or risk premium for worrying. The capital asset pricing model states that this risk premium is equal to the stock’s beta times the market risk premium.

To the company, the message is that work towards reducing the fluctuation in prices of your stock by maintaining good dividends and returns. If your beta is higher than competitors in the industry, then your stock will be expensive to risk-averse investors. There is little doubt that the CAPM is too simple to capture everything that is going on in the market. If you had bought the shares with the smallest market capitalizations and sold those with the largest capitalizations, this is how your wealth capitalizations and sold those with the largest capitalizations. This is how your wealth would have changed.