======capital_asset_pricing_model======
The [[Capital Asset Pricing Model]] (often shortened to CAPM) is a famous, and famously debated, financial model used to determine the theoretically appropriate required rate of return for an asset. In simpler terms, it tries to answer the question: "Given its risk, what return should I expect from this investment?" The model links an investment's expected return to the return of a supposedly risk-free asset, plus a premium for the specific risk of that investment. It was a groundbreaking idea in the 1960s, earning its creators a Nobel Prize and becoming a cornerstone of [[Modern Portfolio Theory]]. For decades, it has been taught in every business school and used by legions of financial analysts. However, from a [[value investing]] perspective, CAPM is often seen as a brilliant but deeply flawed tool that confuses the true nature of risk.
===== The Nuts and Bolts of CAPM =====
At its heart, CAPM is a simple, elegant formula. It calculates the expected return on an investment by taking a baseline return (what you could earn with zero risk) and adding an extra amount to compensate you for the risk you're taking on.
==== The Formula Unpacked ====
The formula looks like this:
**Expected Return on an Asset = [[Risk-Free Rate]] + [[Beta]] x ([[Market Return]] - Risk-Free Rate)**
Let's break down these ingredients:
  * **Expected Return on an Asset:** This is what the model spits out. It’s the annual rate of return you should demand from an investment to make it worth your while. If a stock’s likely actual return is higher than this, it might be a buy; if it's lower, it's a pass.
  * **Risk-Free Rate:** This is the theoretical return you could get on an investment with zero risk of default. In practice, analysts typically use the yield on short-term government debt, like U.S. Treasury bills. The idea is that you wouldn't bother buying a risky stock unless you expected it to earn //more// than this super-safe alternative.
  * **Beta (β):** This is the star of the show and the model's measure of risk. Beta measures a stock's [[volatility]] relative to the overall market (like the S&P 500).
    - A Beta of 1 means the stock tends to move in lockstep with the market.
    - A Beta greater than 1 means the stock is more volatile than the market. A high-flying tech stock might have a Beta of 1.5, meaning it tends to rise 1.5% for every 1% the market goes up, and fall by the same exaggerated amount.
    - A Beta less than 1 means the stock is less volatile than the market. A stable utility company might have a Beta of 0.6.
  * **(Market Return - Risk-Free Rate):** This entire chunk is called the [[Market Risk Premium]]. It represents the extra return investors demand, on average, for choosing to invest in the stock market as a whole instead of sticking with risk-free assets.
===== A Value Investor's Perspective on CAPM =====
While CAPM is academically elegant, value investors like [[Warren Buffett]] and [[Charlie Munger]] have famously dismissed it. They argue that the model is built on a shaky foundation and fundamentally misunderstands what "risk" means for a long-term business owner.
==== Is Volatility Really Risk? ====
The single biggest criticism of CAPM is its reliance on Beta. The model flatly states that volatility //is// risk. If a stock's price bounces around a lot, CAPM labels it "risky" and demands a higher expected return.
A value investor completely rejects this. For them, risk is not a fluctuating stock price; it is the chance of a **[[permanent loss of capital]]**. A stock price dropping might be an //opportunity//, not a risk, as it allows you to buy a wonderful business at a cheaper price. Think about it: if you own a great farm, do you feel poorer if a moody neighbor offers you a ridiculously low price for it one day? Of course not. The farm's earning power is unchanged. A value investor views a stock as ownership in a business, and short-term price swings are just the market's mood, not a change in the business's fundamental worth or riskiness.
==== The Problem with Garbage In, Garbage Out ====
The second major issue is that CAPM's inputs are highly subjective and based on forecasting the future—something humans are notoriously bad at.
  * **Beta is backward-looking:** It's calculated using past price data. A company's sleepy performance over the last five years (resulting in a low Beta) says nothing about the disruptive competitor that just entered its market.
  * **The Market Risk Premium is a guess:** No one knows what the market will return next year or over the next decade. Analysts use historical averages, but the past is not a perfect guide to the future. Plugging a slightly different guess for the market return can drastically change the "required return" calculated by the model.
===== So, Is CAPM Useless? =====
Not entirely. While you should //never// rely on CAPM to calculate a precise [[intrinsic value]] or make a final investment decision, understanding it is useful.
  * **It explains market behavior:** CAPM is deeply embedded in the thinking of institutional investors and Wall Street. Understanding the model helps you understand //why// the market might be pricing a volatile stock cheaply or a stable stock richly.
  * **The core concept has merit:** The idea that investors should demand a higher return for taking on more risk is fundamentally correct. The disagreement lies in how one defines and measures that risk.
For a value investor, the takeaway is simple: know what CAPM is, understand its profound limitations, and then set it aside. Your focus should be on understanding a business, judging its long-term earning power, and buying it with a sufficient [[margin of safety]]—not on a formula that mistakes volatility for risk.