It explains the relationship between the expected return on assets, particularly stocks where systematic risk is involved. Thus, the concept of Beta (β) is central to this model, as it measures the systematic risk of a stock. The model assumes that investors hold fully diversified portfolio and thus want a return that compensates them for bearing the systematic risk, rather than the total risk. So, capital asset pricing model (CAPM) evolved as a way to measure the undiversifiable or systematic risk of a stock or portfolio of stocks. Therefore, when calculating the expected or appropriate return, the systematic risk is what an investor should focus upon. Thus, Total Risk = Systematic risk + Unsystematic risk This risk can be reduced through diversification. Unsystematic risk – This is a risk that is inherent to a specific company or industry. This type of risk is both unpredictable and non-diversifiable in nature. Systematic risk – This is a risk that is inherent to the entire market or a market segment. The model was developed by Nobel laureate William Sharpe in 1970 and states that every individual investment comprises of two kinds of risk:.This is well explained by the Capital Asset Pricing Model (CAPM)that provides a methodology to quantify risk and translate that into expected return on equity. Problems with Capital Asset Pricing Model Table of ContentsĪdvantages of Capital Asset Pricing Model Moreover, equity investments demand higher returns.
So, understanding the risk-return trade-off is of utmost importance for any investor while making an equity investment. Investment in the stock market is comparatively riskier and no matter how much an investor diversifies his investments, some level of risk will always be there.
So, it can be understood that the concept of risk and return go hand in hand.
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