Why do investors use CAPM?

Investors use the Capital Asset Pricing Model (CAPM) for several reasons, including:

  1. Estimating expected return: The CAPM provides a framework for estimating the expected return on an investment based on the asset’s risk, which can help investors make more informed investment decisions.
  2. Determining cost of capital: The CAPM can be used to determine the cost of capital for a company or project, which is important for evaluating investment opportunities and making financing decisions.
  3. Asset pricing: The model can be used to price assets by discounting their expected future cash flows at the appropriate discount rate, which is determined using the CAPM.
  4. Portfolio optimization: The CAPM can be used in portfolio optimization, which involves constructing a portfolio of assets that maximizes expected return for a given level of risk, or that minimizes risk for a given level of expected return.
  5. Performance evaluation: The CAPM can be used to evaluate the performance of a portfolio manager or an individual asset by comparing the expected return to the actual return, and assessing whether the return is due to skill or luck.

While the CAPM has some limitations and assumptions that are not always met in real-world situations, it is still widely used in finance as a benchmark for estimating expected return and evaluating investment opportunities.