I am a new investor. What are the advantages and disadvantages of using the CAPM?

CAPM is a theory that builds on modern portfolio theory that says that you should only care about being rewarded for market risk -- since other types of risk disappear in a well diversified portfolio.

For example, if you own both Pepsi and Coke stock -- you will still experience market risk -- but if something happens that is good for Coke and bad for Pepsi (or the other way around) the good news and bad news cancel each other out. Since you can get rid of this risk, you aren't rewarded.

CAPM goes on to say that you can create a portfolio where some money is put into the market and some is put in the risk-free asset (e.g., T-Bills). You can pick the level of risk that you want. With this strategy, the expected payoff (average payoff) is a linear function of the risk you take on. Bill Sharpe called the level of risk "beta."

In his theory, the expected return of the portfolio is:

E[Rp] = Rf + b*E[Rm-Rf]

or the average return on your portfolio is equal to the risk free rate plus beta times the average excess return of the market over the risk free asset.

Since anyone can create this portfolio, the reward you get for a particular stock should be related to its contribution to the market portfolio -- its beta.

The big advantage to this is that you can compute the expected return of any asset. You can see how it contributes to the risk of your portfolio. You can choose a portfolio that maximizes the expected return for a given level of risk. It was a brilliant idea, and Sharpe deserved his Nobel Prize.

Now -- what is the drawback? The big drawback is that Sharpe's Market Portfolio is really every asset in the world -- including those that don't trade. People apply it to the stock market -- so they are using an incomplete set of information. The big problem is that there may be other factors that affect returns besides the stock market. Steve Ross came up with an extension of CAPM called Arbitrage Pricing Theory. APT is an extension that allows you to use multiple factors -- not just market returns.

Hedge Funds use very sophisticated models that really come down to measuring risk and reward with extensions of CAPM.

CAPM has other uses -- like helping in determining hurdle rates for taking on corporate projects.

This material is taught in introductory MBA finance classes.

If you're a new investor, CAPM is the least of your problems. Find a good balanced mutual fund and put your money there, OR find a good Financial Advisor.

the capm is theoretical, its just good basis to learn off, using this in financing examples gives us outcomes that can be used intuitively, i would not base any investment solely on the capm. The capm would be good if all investments in the world were made with a perfect portfolio, causing perfect equilibrium among all securities, but guess what, that isnt the real deal.

The CAPM basically states that your return on an investment is going to be related to the beta of the investment. The higher the beta the higher the return. Also the higher the risk, I might add. An investment with a beta of 2 should have 2x the return as stocks in general. One problem is that no one knows what the future beta of an investment will be, therefore people make the assumption that the future beta will be the same as the past beta, which can be calculated. This is a bad assumption but in general it does seem to apply much of the time.

One consequence of CAPM unfortunately, is the when the prices of stocks drop which they do from time to time, those stocks with high betas tend to drop like rocks.

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