The basics — why this matters
Chapter 1 of 6 · 4 min
Based on historical data, the stock market shows a clear relationship between risk and return, where stocks with higher volatility generally offer higher expected returns to compensate investors for the extra risk.
The behavior of the stock market is not random but follows underlying systematic patterns that can be quantified and analyzed. A central part of this is the concept of beta, which measures a stock's sensitivity to movements in the broad market. A stock with a beta of 1,0 moves on average as much as the market, while a beta of 1,5 means the stock is expected to move 50% more than the market in both positive and negative directions. This quantification of systematic risk is crucial for understanding the potential reward for taking a specific risk.
To value a stock correctly, we must understand its expected return in relation to its risk. This is where CAPM (Capital Asset Pricing Model) comes in as a powerful framework. The model proposes that the expected return on an asset equals the risk-free rate plus a risk premium, where the size of the risk premium is determined by the asset's beta and the market's risk premium.
Without this model, an analyst risks either undervaluing a high-return but risky stock or overvaluing a stable but low-return stock.