The Formula That Tells You What Risk Should Pay
A friend pitches you a stock: "It returned 9% last year, that's solid." But the stock has a beta of 1.6, meaning it swings 60% harder than the market. Is 9% actually good compensation for that wild ride? Run the Capital Asset Pricing Model with a 4.5% risk-free rate and a 6% market risk premium, and the answer is sobering. This stock should return at least 4.5% + 1.6 × 6% = 14.1% to justify its risk. A 9% return on a 14.1% risk demand is not a win, it is overpaying for danger.
CAPM answers a question every investor should ask but rarely does: how much return should this investment pay me for the risk I am taking? The model rests on a clean idea. You deserve a baseline return just for parking money safely, the risk-free rate, usually proxied by Treasury yields. On top of that, you deserve extra return for taking on market risk, and the size of that extra depends on how risky the specific stock is relative to the market, captured by its beta.
The formula is short enough to memorize. Expected return equals the risk-free rate, plus beta times the market risk premium, where the market risk premium is the market's expected return minus the risk-free rate. In plain terms: safe baseline, plus a risk bonus scaled to how violently the stock moves. A beta of 1.0 earns the full market premium. A beta of 0.5 earns half. A beta of 2.0 earns double, because you are taking double the market exposure.
The output is a required rate of return, and that number is a verdict. If a stock's expected future return clears its CAPM required return, it looks attractive, priced to reward you for the risk. If it falls short, the stock is asking you to accept too little for too much volatility. This is why analysts use CAPM as the discount rate in valuation models and as the cost-of-equity input when companies decide whether a project earns its keep.
This calculator does the math and draws the Security Market Line. The Security Market Line is a graph plotting required return against beta. Every fairly priced asset sits on the line. A stock above the line offers more return than its risk demands, a potential bargain. A stock below the line offers too little, a potential trap. Enter your risk-free rate, market return, and the stock's beta, and you get both the required return and a visual read on whether the market is paying you fairly.