# Assumptions of the CAPM

As to my understanding, the CAPM assumes that all investors behave as described in the portfolio theory. Consequently, all investors hold a combination of the risk-free investment and the efficient portfolio (the portfolio with the highest Sharp ratio). I have two questions:

1. It is said that CAPM is an equilibrium model. What exactly does that mean in this context?
2. If it is assumed that all investors hold the efficient portfolio (only with the distinction of how large the share of the portfolio is compared to the risk-free investment), why should an investor use the model to calculate the expected return on an individual stock? The stock is already contained in the Market Portfolio, which is held by every investor. Investing a higher amount in a stock shpuld consequently lead to a deviation from the market portfolio(?) Wouldn't the use of the model then argue against its assumption?
• You would calculate the expected return on the stock, not to decide if you want to buy more of the stock or not, but for other reasons. For example a company which has issued stock might be interested in estimating the return its shareholders expect and use that to guide decisions about projects or financing it will have to make. Plus it would be a major intellectual achievement if an accurate theory of expected returns could be devised. But you are right: implication of CAPM is that the typical investor should just buy an index fund and not look at expected returns on individual stocks. Sep 29, 2020 at 18:32
• Also assume you make the standard assumptions required for CAPM. Now if the expected return of some security were to deviate from the CAPM value, holding the market portfolio would not be optimal and this would not be an equilibrium.
– fes
Sep 29, 2020 at 19:58
• Good point.. If you make your own estimates of ER, you can use the CAPM ER as a "neutral" point. If your estimate for a stock is higher than this you buy it and if it is lower you short it. And the Treynor-Black formula can be used to do this. en.wikipedia.org/wiki/Treynor%E2%80%93Black_model Sep 30, 2020 at 10:21