Let’s say you’re sitting down to decide between a couple of different investments. You’d rather put your capital in just one, instead of spreading it out among the group, and you feel equally confident in all of them.
How to decide? One tool might be the capital asset pricing model (CAPM), which measures the expected return of an investment relative to the risk assumed. In theory, an investment’s expected return is directly proportional to its risk. The riskier the investment, the higher a return the investor expects to make.
Now, a lot of investment risk is managed through diversification, the art and science of putting different investments together to balance each other’s risk out. When one asset class or sector is declining, another, non-correlated one, may likely be ascending.
But not all risk can be diversified away, because some risk is inherent in the market itself. Factors like interest rates, exchange rates, geopolitical events, and recessions affect the market as a whole, albeit not evenly.1
The CAPM uses the risk-free rate, the asset’s beta, and the historical market return to describe a return on investment that accounts for the risk the investor has taken on. The investor can then decide whether they think that return is likely over their intended time frame.
Understanding the Capital Asset Pricing Model
Let’s dig into the elements that go into the model.
Risk-free rate—This is the rate an investor would expect from an asset that bears no risk. Treasury rates are typically used as the “risk-free” rate, since these bonds are widely considered to be very low risk since they’re backed by the full faith and credit of the U.S. government. Choose a bond that’s consistent with the investment’s expected time horizon.2 For example, if you’re planning to hold an investment for 10 years, the 10-year Treasury would probably be the one to choose.
Beta—Volatility is a statistical measure of how much an asset’s price fluctuates. While risk encompasses more than price fluctuations, volatility is a significant contributor to risk. A stock’s beta measures the volatility of its returns relative to the overall market. A stock with a beta of 1 exhibits the same level of volatility as the market, while a beta of less than 1 indicates the stock is less volatile than the market. It follows that a beta of more than 1 indicates the stock is more volatile than the market. Beta is therefore used as a measure of a stock’s level of risk relative to the market.3 You can find an investment’s beta on sites like Bloomberg, Yahoo Finance, and others.
Market risk premium—This is the excess return over the risk-free rate that an investor expects in order to compensate for holding a risky market portfolio. The more volatile the market or asset class, the higher the market risk premium will be.4 Typically, investors use the historical returns of a broad-market index to quantify the market risk premium, although some professional investors will use their own market projections.
The CAPM Formula and How to Use It
Now that we’re familiar with these inputs, let’s look at the formula.
ERi = Rf + ß(ERm - Rf)
Where:
- ERi =Expected return of investment
- Rf=Risk free rate
- ß=Beta
- ERm=Market return
As an example, let’s calculate the expected return for a stock we’ll call ACME.
First, we need the current risk-free rate, which is the 10-year Treasury yield. This was 4.24 as of June 30, 2025.5
Next, we need the market return to calculate the market risk premium. From 1957 to the present, the S&P 500 Index has averaged an annual return of 10.47%.6
ACME has a beta of 1.5, meaning that the stock is 1.5 times as volatile as the S&P 500.
Therefore: the expected return for ACME is 4.24 + 1.5(10.47-4.24), or 13.56%.
The CAPM tells us what return we should expect for an asset’s given level of risk. In the case of ACME, if the stock is yielding less than 13.56% annually, investors aren’t receiving a return commensurate with the risk they’ve assumed.
That information can then help you decide if this investment is one you want to make. Are there reasons the return will be different going forward? It might be worth investing in. If not, it may be worth reconsidering.
CAPM and Fair Value
The CAPM is one tool often used across the financial industry to determine whether a stock is fairly valued, and it also plays a key role in financial modeling and asset valuation.
For example, when an analyst values a company, they might use the weighted average cost of capital (WACC) to find the net present value (NPV) of future cashflows. Based on the company’s capital structure (i.e., 80% equity, 20% debt), the WACC equation uses the expected value calculated from the CAPM as the cost of equity, and it does the same for the cost of debt. It then adds those two values together to get the WACC.
Analysts project future cash flow over a multiple year period, then discount those values to the present using the WACC, then divide by the number of shares outstanding to arrive at the fair value of the stock.
A value investor is often making investment decisions based on the current price relative to fair value. If the current price is lower than the fair value, it’s a buy. If it’s higher than the fair value, it’s not.
Pros and Cons: The Bottom Line on the CAPM
The principal criticisms of the CAPM center around the ambiguity of inputs, since the output of a model is only as good as what goes in.
Take the risk-free rate, for example. Over the investment time horizon, the risk-free rate can fluctuate, sometimes considerably. In a valuation, a higher risk-free rate would increase the cost of capital while a lower rate would reduce it. Either will significantly impact the valuation.
The beta calculation can also be misleading as a measure of volatility. Beta is calculated through a statistical regression of historical stock returns. However, historical stock returns don’t follow a normal distribution. In addition, upward and downward price movements are not equally risky, which calls the beta into question as a completely accurate measure of risk.
Finally, the market risk premium is based on a theoretical value and the choice of that value is subjective. Even using a historical average from a major index is imperfect, as there’s no guarantee that the market will perform similarly in the future.
All that being said, the CAPM remains widely used despite its reliance on a variety of assumptions. Combined with other methods of evaluating securities, it can play an integral role in helping investors make informed decisions.
How Can the Individual Investor Benefit from Using the CAPM?
While the CAPM is more commonly used by professional investors, especially in valuations, it can also be useful for individual investors.
Establishing realistic expectations: By providing a framework to estimate the expected return of an asset, the CAPM can help you set realistic expectations for your investments. Most investing is in the service of larger financial goals, and having realistic expectations can help you make the choices that will serve those larger goals.
Comparing investments: You can use the CAPM to compare different investment opportunities, assessing whether the expected return implied by an investment’s risk is reasonable.
Risk-adjusted performance: For investments you already have, the CAPM can help you understand whether a portfolio or asset is delivering returns commensurate with the risk you’ve assumed. This can help you make better investment decisions and portfolio adjustments.
The Takeaway
Like the Sharpe Ratio, the CAPM plays an important role in helping investors understand the relationship between risk and return. Where the Sharpe Ratio is backward-looking and used to assess risk-adjusted return, the CAPM helps investors estimate the kind of returns an investment would need to yield to make up for the amount of risk assumed.
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