Harry Markowitz established Modern Portfolio Theory (MPT) and the investment concept of diversification in 1952. One of Markowitz’ doctoral students, William Sharpe, streamlined his work and developed a more accessible approach to diversification known as the Capital Asset Pricing Model (CAPM). For their work, both individuals were awarded the Nobel Prize in Economic Sciences in 1990.

The Capital Asset Pricing Model expands Modern Portfolio Theory in two ways. First, it considers both risky and risk-free assets. Second, it breaks down investment risk into two distinct components – systematic and unsystematic risk.

Understanding the Capital Asset Pricing Model

In the Capital Asset Pricing Model, an investment portfolio is divided between risky and risk-free assets, where “risk-free” means that the investment return is known with certainty. Traditionally, the risk-free investment is represented by short-term Treasury bills or a FDIC insured savings account.

The idea is that investors can always invest in the risk-free asset and have a guaranteed return. For example, if you invest your money in a reputable savings account, you will earn the stated interest rate. There are no additional risk factors to consider, and everyone earns the same “risk-free” interest rate.

Different Types of Investment Risk

Most investments are not risk-free. For example, stocks are inherently risky. Although an investor expects to earn a positive return when purchasing a stock, he might be disappointed or pleasantly surprised in the performance over time, because fluctuations in stock prices will impact the investor’s return on investment.

The future value and expected rate of return depend on a number of risk factors that are unknown when the investment is made. CAPM suggests that these potential risk factors can be broken down into two different categories.

The first type of risk, called systematic risk, is common to all risky assets. Systematic risks include:

Tax code or interest rate changes

Expectations of other market participants (investors)
Currency fluctuations, inflation, and the potential for a recession.
Systematic risks cannot be diversified away. Whether you own one stock or several thousand stocks, the value of your investment partially depends on risk factors that are inherent in our modern economy.

The second type of risk, called unsystematic risk, captures the unique risk factors associated with an individual company or sector.

For example, Exxon Mobil (the oil giant) is subject to several unique risks:

New energy alternatives could reduce or replace worldwide demand for fossil fuels
New energy regulations could increase the cost of production, reducing shareholder profits and the value of Exxon stock

These unsystematic risks can be diversified away. Concerns about alternative energies and worldwide demand can be eliminated by owning the entire energy sector, not just companies that produce oil and gas. Concerns about energy regulations can be eliminated by further diversifying the portfolio to include non-energy related sectors, thus reducing the portfolio allocation to the energy sector.

Because these risks are diversifiable, CAPM suggests that investors should not be rewarded for bearing the risk. In other words, any type of unsystematic risk is unrewarded by financial markets and should be eliminated by rational investors through diversification.

The Capital Asset Pricing Model Equation

CAPM combines all of the information discussed thus far into a simple equation:

E(Ri) = Rf + risk premium

In English, the expected return of any risky asset E(Ri) equals the risk-free rate (Rf) plus an expected risk premium for investing in the risky asset.

The risk premium component of the equation does not consider unsystematic risk, which can be eliminated through proper diversification. The risk premium captures only systematic risk, which can further be broken down into the following equation:

risk premium = βi (Rm – Rf)

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