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?
  • $\begingroup$ 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. $\endgroup$ – noob2 Sep 29 '20 at 18:32
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    $\begingroup$ 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. $\endgroup$ – fesman Sep 29 '20 at 19:58
  • $\begingroup$ 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 $\endgroup$ – noob2 Sep 30 '20 at 10:21
  1. It means the supply of all securities equals the demand of all securities, so the market clears and is in equilibrium as in standard economics language.
  2. Indeed, all investors will hold some combination of the market portfolio and risk-free security and will not deviate from this, assuming the assumptions of the CAPM are satisfied, namely that investors have mean-varaince preference, that they agree on the means/sds of returns as well as correlations, and can fund and lend at the risk-free rate. An investor can use the model to calculate the expected return on an individual stock, but again, they should still not deviate from holding the market portfolio and risk-free investment.

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