Series 66: Capital Asset Pricing Model

To understand CAPM, it is important to understand the distinction between systematic and unsystematic risk. Recall that systematic risk is risk attributable to market forces. In other words, it is the risk that the entire market will decline. Unsystematic risk is investment-specific. It is the risk that a particular investment will do poorly because of factors having to do with that investment alone (e.g., poor management, changes in regulation). Unsystematic risk can be diversified away by choosing the right set of uncorrelated or negatively correlated securities. Because unsystematic risk can be minimized through diversification, investors do not expect to be compensated for increase