CAPM – Capital Asset Pricing Model
CAPM claims that the expected return on a security (stock, fund…) is the risk free rate of money plus the investment’s risk premium.
CAPM = Risk Free Rate + Beta*(Expected Market Return – Risk Free Rate)
Risk Free Rate – Typically the going rate on a Treasury Bill is used…The idea here is that there is a time value of money. Simply by saving you will earn X%.
Expected Market Return – Typically this is the S&P500, but if you can identify the rate of return that is a better representation of your asset’s class, then you should use that expected return. For example, if I held an ETF that was based of all Brazilian stocks, I would want to find the expected return on a Brazilian index (Brazil’s main index is the BOVESPA).
Expected return is most likely going to come from a historical average of returns from the index (market).
Beta is an attempt to capture the greater or less risk a investment has compared to the market. Click Here to watch my video discussing beta.
Bottom Line - When you need to estimate what return on investment you should expect from a stock or fund you hold, the CAPM model is a quick and easy way to get a rough estimate. It’s not the best model in the world, but it is simple, easy to use and effective at providing an understanding of the premium you should receive from the risk you’re taking.