CALCULATING EXPECTED RETURNS USING THE CAPITAL ASSET PRICING MODEL

If you invest in Microsoft, what return do you expect on your investment?  8 percent? 12 percent? 20 percent?  Would you expect different returns on the same investment in AT&T?  You should, because investments in these companies don't involve the same degree of risk.  The CAPM provides an easy-to-use formula for calculating expected returns on individual stocks based upon their risk: 

Where: E(ri) is the expected return on stock i  rf is the current risk-free rate (the rate of return on investments with virtually no risk, such as U.S. Treasury bills) Bi is the beta for firm i  E(rM) is the expected return on the overall market

Suppose a technology company called Risky.com has a beta of 2, the expected return on the market is 10 percent, and the current risk-free rate is 5 percent.  What is the expected return on an investment in Risky.com?  Plugging these numbers into the formula, we find that we should expect a return of 15 percent for Risky.com. 

You now have an introduction to a concept that has helped many people achieve their financial goals.