Why does one stock trade at a price that assumes a 6% annual return while another trades at a price that assumes 14%? The Capital Asset Pricing Model, or CAPM, answers that question. Developed by economist William Sharpe and built on Harry Markowitz’s portfolio theory, CAPM calculates the return an investor should expect from an asset based on how risky that asset is compared to the overall market. It is the bridge between the diversification ideas in modern portfolio theory and a single, usable number: an asset’s expected return.

The CAPM formula. CAPM builds directly on the idea of systematic risk — risk tied to the overall market or economy that cannot be diversified away, such as a recession or an interest-rate change. Because unsystematic, company-specific risk can be diversified away by holding a broad portfolio (the lesson of modern portfolio theory), CAPM assumes investors should only be compensated for the risk they cannot diversify away: systematic risk, measured by a number called beta.

Expected Return = Risk-Free Rate + Beta × (Expected Market Return − Risk-Free Rate)

The term in parentheses — the expected market return minus the risk-free rate — is called the market risk premium. It is the extra return investors demand for taking on the risk of the market instead of holding a risk-free asset, such as a short-term government security. Multiplying that premium by beta scales it to the specific asset: a stock that moves more than the market (beta greater than 1) is expected to earn more than the market premium; a stock that moves less (beta less than 1) is expected to earn less.

Worked example. Suppose an investor is evaluating two stocks. Treasury bills — a common stand-in for the risk-free rate — currently yield 3%, and the investor expects the overall stock market to return 9% over the coming year. That makes the market risk premium 9% − 3% = 6%.

Stock A has a beta of 1.4, meaning it has historically moved about 40% more than the market in either direction. Its expected return under CAPM is: 3% + 1.4 × (9% − 3%) = 3% + 1.4 × 6% = 3% + 8.4% = 11.4%.

Stock B has a beta of 0.6, meaning it has historically moved only about 60% as much as the market. Its expected return under CAPM is: 3% + 0.6 × (9% − 3%) = 3% + 0.6 × 6% = 3% + 3.6% = 6.6%.

Because Stock A carries more systematic risk than the market, CAPM says investors should demand a higher return to hold it. Stock B, which moves less than the market, has a lower required return — but is also expected to fall less in a downturn.

What beta tells you. A beta of 1 means the asset tends to move in line with the overall market. A beta greater than 1 means it tends to amplify market movements — bigger gains in a rally, bigger losses in a downturn. A beta less than 1 but positive means the asset moves in the same direction as the market, but less sharply, common for stable, established companies. A negative beta — rare, but valuable for diversification — means the asset tends to move opposite the market. A higher beta means a higher expected return under CAPM, but expected return is not guaranteed return: beta describes how an asset has tended to move relative to the market, not what will happen next.

Limitations of CAPM. CAPM is one of the most widely used models in finance, but it rests on simplifying assumptions worth knowing: it assumes markets are efficient and all investors have access to the same information, that investors hold fully diversified portfolios so only systematic risk matters, and that beta — typically calculated from past price movements — remains stable over time. In practice, betas shift, markets are not perfectly efficient, and real returns often diverge from what CAPM predicts. Analysts frequently treat CAPM as a useful starting estimate rather than a precise forecast.

Related reading: Modern Portfolio Theory covers the diversification concepts CAPM builds on. Standard Deviation: Measuring Investment Risk covers how total investment risk is measured and calculated. Understanding Investment Risk is a plain-language introduction to risk types.