What Are the Advantages and Disadvantages of CAPM?
According to Investopedia, the main advantage of the Capital Asset Pricing Model, or CAPM, is that it helps investors calculate risk when contemplating high-risk investments. The main disadvantages of CAPM are that some studies question its validity and that it may not always be accurate in its risk assessment.
In 1970, William F. Sharpe put forth the CAPM model in his book “Portfolio Theory and Capital Markets.” In 1990, largely as a result of this early work, he received the Nobel Prize for Economic Sciences together with Harry M. Markowitz and Merton H. Miller, each of whom contributed to the establishment of financial economics as an individual field of study, according to the official website of the Nobel Prize.
CAPM posits that there are two types of investment risks, and the risk of a specific portfolio is calculated by factoring in both. Systematic risk involves general market conditions, such as recessions, interest rates and war, over which investors have no control. Unsystematic risk, or specific risk, is inherent in individual stocks. According to modern portfolio theory, unsystematic risk can be reduced by diversification. CAPM is a way to measure the risk in relation to the expected return. The volatility of a stock is calculated by a coefficient called “beta.” The CAPM theory states that investments with higher risk will always earn an investor more, a supposition that dominates modern financial thinking.