Investing 101

Lesson 3: New Investment Technology

Capital Asset Pricing Model

Other academic Economists, William Sharpe, John Lintner, and Fischer Black, took MPT a step further and developed the Capital Asset Pricing Model (CAPM) to show what part of a security's risk can or can not be eliminated by diversification. Sharpe also received the Nobel Prize in 1990. In this week's exercise, you'll get a chance to practice Sharpe's theories using his online portfolio assessment tool.

CAPM separates stocks into systematic and unsystematic risk. Systematic risk (market risk) is made up of the basic variability of stock prices and reflects the tendency of a stock to move up or down with the general market. Unsystematic risk looks at the unique factors that affect an individual company, such as the possibility of a strike or the development of a new product.

One way to measure risk is with Beta. Beta shows a stock's relative volatility or sensitivity to market moves. It compares the movement of an individual stock (or portfolio) to the movements of the market as a whole. For example, if your benchmark is the S&P 500, the Beta for that benchmark would be 1. A stock (or portfolio) with a Beta of 2, swings twice as far as its benchmark. Investors face the ups and downs of the benchmark itself and even with a Beta of 1 there is still risk. CAPM theorists believe that all unsystematic risk can be eliminated by diversification, so investors are rewarded for taking systematic risks.

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