From Portfolio Theory to Asset Pricing
The Capital Asset Pricing Model (CAPM) is the bridge between Markowitz's portfolio theory and a theory of how assets are actually priced in markets. Markowitz told investors how to combine assets optimally; CAPM asks what must be true about prices if all investors do exactly that.
The model was developed independently and near-simultaneously by William Sharpe (1964, Journal of Finance), John Lintner (1965, Review of Economics and Statistics), and Jan Mossin (1966, Econometrica). Sharpe received the Nobel Prize in 1990, shared with Markowitz and Merton Miller. CAPM begins from a set of strong assumptions: investors are rational and mean-variance optimisers, they have identical beliefs about expected returns and covariances, they can all borrow and lend at the same risk-free rate, markets have no taxes or transaction costs, and all assets are perfectly divisible and liquid.
The Central Prediction
If every investor holds the efficient frontier portfolio that is optimal for their risk tolerance, and they all agree on what that frontier looks like, what portfolio does each investor hold? CAPM's answer: they all hold the same risky portfolio — the market portfolio. The market portfolio contains every investable asset in proportion to its market capitalisation.
This is a striking conclusion. It implies that in equilibrium, the market portfolio is the tangency portfolio — the risky portfolio with the highest Sharpe ratio. Any other combination of risky assets would be inefficient.
From this, CAPM derives the Security Market Line (SML): the expected return of any asset equals the risk-free rate plus beta multiplied by the equity risk premium.
Expected Return = Risk-Free Rate + Beta × (Market Return − Risk-Free Rate)
Beta measures the asset's sensitivity to market movements — its systematic risk. An asset with beta of 1.5 is expected to return 1.5 times the market's excess return. An asset with beta of 0.5 is expected to return half the market's excess return.
What CAPM Says About Risk
CAPM draws a sharp distinction between two types of risk. Systematic risk (also called market risk or non-diversifiable risk) is the risk that cannot be eliminated through diversification — it moves with the whole market. Unsystematic risk (idiosyncratic or diversifiable risk) is company- or sector-specific and can be eliminated by holding a diversified portfolio.
The radical implication: investors are not compensated for bearing unsystematic risk. If you hold a concentrated portfolio of three technology stocks, you are taking on enormous unsystematic risk, but the market will not reward you with higher expected returns. Only systematic risk — beta — earns a return premium. This underpins the entire case for broad diversification.
CAPM's Legacy and Vocabulary
Despite decades of empirical challenges, CAPM remains the conceptual vocabulary of professional investment. Alpha and beta are used daily across the industry. Performance attribution, manager evaluation, and risk budgeting all build on CAPM concepts. Fee structures for active managers are often justified (or critiqued) in terms of whether they deliver genuine alpha.
The model's clean logic is also used as a building block: the Fama-French three-factor model and subsequent multi-factor models extend CAPM by adding additional systematic risk factors (size, value, momentum) that historical data suggests carry their own return premia. These extensions acknowledge CAPM's empirical weaknesses while preserving its logical structure.