Capital Asset Pricing Model (CAPM): How Rich Will You Be?

One of the biggest reasons that people do not invest in the stock market is because they are afraid to lose money (AKA risk aversion). But there are several ways to estimate what the return on a stock should be in the future. One of them is the Capital Asset Pricing Model (CAPM). Let me show you how it works.

What is the Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model is a formula that is used in financial circles to help estimate the return on a stock. It does this by attempting to quantify the relationship between systematic risk and the future price of a stock.

But it is important to understand that this is an ESTIMATE. No one knows what a stock price will look like in the future and therefore will not be able to tell you with certainty what a stock price will look like with certainty at a later date. And if someone says that they can, then do NOT take investment advice from them.

Inputs to CAPM

Get ready to do some math.

Here is the formula for the Capital Asset Pricing Model:

R_Investment  = R_Free + ꞵ (R_Market – R_Free)

Here is what each of these inputs mean:

R_Investment

This is the number that you are solving for. “R” means Return. This is the expected return on the investment.

R_Free

This is the Risk free rate. Any time you see a “Risk free” rate, think of a US treasury bill. They are extremely safe (as close to risk free as possible) but offer a relatively low return. Typically the number that is used for this input is the 10-year US Treasury return.

At the time of this writing (January 2024) the 10-year US Treasury rate is 3.96%.

Ꞵ

This symbol is the Greek symbol Beta. This is used to estimate the risk of an investment as compared to the overall market.

Here’s how it works

In order to determine this it has to be benchmarked to something. That “something” is the whole stock market. Usually analysts use the S&P 500 for this.

So to figure out how much risk a particular investment has, it is in comparison to the S&P 500. An investment might have more risk than the S&P 500 or less risk than the S&P 500.

The S&P 500 has a beta (measure of risk) of 1.0. 

If another investment has a beta of 1.0, that means that it has just as much risk as the S&P 500.

If an investment has a beta of 2.0, that means that it has twice as much risk as the S&P 500.

If an investment has a beta of 0.5, that means that it has half as much risk as the S&P 500.

You get the picture. 🙂

R_Market

This is the estimated risk of the overall market.

Most people (including myself) will generally use the S&P 500 as the overall market but there are scenarios where you would want to use another benchmark.

If you are analyzing a tech stock or a high growth company you might want to use something like the NASDAQ or a comparison to a high growth ETF or index fund.

Shortfalls of CAPM

The Capital Asset Pricing Model is not perfect.

In fact, no formula to determine the price of a stock is perfect because in order to be perfect, you would have to have a crystal ball. No one knows the future and no one can predict what will happen in the future. There are simply too many variables. In fact, there are an infinite amount of variables.

So here are some of the shortfalls of CAPM.

1. CAPM assumes that investors have a large amount of diversification in their portfolio.
2. It can only give you an estimate for the next period, not an ongoing estimate of the return of the stock.
3. It assumes that all investors can borrow and lend at the risk free rate (which is not always possible).

CAPM Example

Here is how the Capital Asset Pricing Model works.

Let’s take Netflix as an example.

We already have some of our inputs. 

The risk-free return rate is 3.96% (the 10-year US Treasury rate).

The return on the market is 10.03% (the average 30-year return of the S&P 500).

The Beta for Netflix is 1.28 (I simply looked this one up online).

Now let’s put them into the formula:

R_Investment  = R_Free + ꞵ (R_Market – R_Free)

R_Investment  = .0396 + 1.28 ( .1003 – .0396)

= .1173 OR 11.73%

So based on the CAPM calculation, it is estimated that Netflix will return 11.73% over the next period (usually a year).

But remember, if ANY of the inputs change, the CAPM calculation will need to be redone.

Final Thoughts

CAPM is a little more advanced in the world of investing than the average investor needs to be worried about. 

In fact, as I’ve said before (several times), just spend your time investing in ETFs and index funds that track the market. That way you don’t have to worry about as much risk as well as doing these calculations.

But if you choose to go the rout of investment analysis, technical analysis, and/or fundamental analysis, this is a good place to start.

You can do this!

I am here for you!

Until next time!