Portfolio Theory

CAPM has its methodological foundations in William Sharpe’s portfolio theory. This theory introduced the concepts of systemic risks and unsystemic risks in market investing. Systemic risk is the risk of losing part of your investment that is inherent to the entirety of the stock market. Unsystemic risks are risks associated with a specific investment losing value. These concepts led to modern portfolio theory, which holds that sufficiently diversifying your portfolio protects you from unsystemic risks.

CAPM Definition

Limitations

Many of the limitations to the CAPM lie in its methodological assumptions. The major components of the model’s equation, the relative volatility of the investment, relies on the ability to measure the volatility of the market as a whole. This requires being able to accurately assess the volatility of every single possible investment in the market. This is not possible. Those who implement the CAPM model use a proxy, such as the S&P 500, to represent the overall volatility of the market. However, this is not the true measure the model would require to be accurate. Consequently, the model can only give approximate predictions.

Riskiness as Measure of Performance

References

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