Diversification is protection against ignorance. It makes little sense if you know what you are doing. -Buffett
“Diversification is like a seatbelt, while concentrated investing is a skillful maneuver.”
Right now, I’m still in the learning-to-drive stage, so it makes total sense to keep the seatbelt (diversification) on.
Once I truly learn to think like a business owner — understanding companies, analyzing their moats, and valuing them properly — then I can start practicing concentrated bets.
So for now, I’m still happily investing in index funds, haha.
The marginal benefit: The benefit of adding an asset to a portfolio will decrease as you increase the number of assets in your portfolio.
Capital Asset Pricing Model (CAPM)
🌊 What’s the Risk That Really Matters?
When you invest in a stock (say, Apple), what risk should you care about?
Not how volatile Apple is on its own…
But how much extra risk it adds to your entire portfolio — especially the market portfolio.
🔄 Why? Because…
You can eliminate company-specific risk through diversification (as we said earlier).
But the risk that can’t be diversified away — the market-related risk — is what matters.
📈 So how do we measure that market-related risk?
➤ We use something called Beta
Think of beta as:
“How much does this stock move with the market?”
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If beta = 1 → the stock moves just like the market.
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If beta = 0.5 → it moves half as much as the market.
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If beta = 0 → it doesn’t move with the market at all.
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If beta = -1 → it moves opposite the market (rare).
This is why beta is sometimes called a measure of sensitivity to market swings.
💰 So what return should you expect?
If you take more risk, you should expect more return, right?
That’s where this idea comes in:
The more market risk (beta) an asset has, the higher the return you should demand.
This is exactly what the CAPM formula tells us:
📊 Plain-English version of the CAPM:
Expected Return = Safe return (T-Bill) + Extra reward for taking market risk
And how much “extra reward”? That depends on:
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How risky the market is (called the market risk premium)
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And how “sensitive” your stock is to that market risk (beta)
✅ Quick Example:
Imagine:
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Risk-free rate = 2% (a T-Bill)
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Market return = 8%
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Beta of a stock = 1.5
Then you’d expect:
2% (safe) + 1.5 × (6% extra market reward) = 11% expected return
So you’d only want to buy that stock if you believe you’ll earn at least 11% over time — otherwise it’s not worth the risk.
🧠 Why this matters to you:
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CAPM helps you decide what return is fair for a stock, based on its risk.
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If the price of a stock implies a lower return than CAPM suggests, it might be overvalued.
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If it implies a higher return, it might be undervalued — that’s where value investing begins.
Alternatives to the CAPM
🔧 1. Modified CAPM
These models still use the basic CAPM logic, but relax some of its strict assumptions.
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For example, they might allow for:
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Taxes (since investors don’t get to keep 100% of their returns)
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Transaction costs (which exist in the real world)
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Different beliefs about the future (instead of everyone agreeing)
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Think of this as: “Still CAPM, but more realistic.”
🌍 2. Extended Versions (More Risk Factors)
➤ a) Arbitrage Pricing Theory (APT)
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This model says: “There isn’t just one market risk factor — there could be many.”
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But it doesn’t name them — it just assumes they exist and affect returns.
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It’s built using statistics to find patterns in how returns move together.
APT is like saying: “Returns are influenced by mystery forces — we can’t name them, but we know they’re there.”
➤ b) Multifactor Models
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These go one step further: They try to name the risk factors.
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Common examples:
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Interest rates
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Inflation
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GDP growth
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Oil prices
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Credit spreads
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These models ask: “What big-picture things move the market?”
And then they say: “Let’s build a model around those.”
Famous example: The Fama-French Three-Factor Model:
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Adds two extra factors to the market:
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Size (small vs. large companies)
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Value (cheap vs. expensive stocks)
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🔍 3. Proxy Models
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These don’t try to build a perfect theory.
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Instead, they say:
“Let’s just look at what has worked in the past — what kinds of stocks earned higher returns?”
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Then we use those characteristics as proxies (stand-ins) for risk.
Common proxies:
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Low price-to-earnings (P/E) ratio
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High dividend yield
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Low price-to-book (P/B) ratio
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High past earnings growth
This approach is very data-driven and is often used by quantitative investors and factor-based funds.
🧠 Summary Table:
| Model Type | Key Idea |
|---|---|
| CAPM | One market risk, simple logic |
| Modified CAPM | CAPM + real-world frictions (taxes, costs) |
| APT | Many unnamed risk factors (statistical) |
| Multifactor Models | Many named macroeconomic risks |
| Proxy Models | Use past return patterns as stand-ins for risk |
🧠 What Is the Question Really Asking?
What assumption must we make in order to say: “Only non-diversifiable (market) risk will be reflected in the stock’s price”?
In other words:
Why do we believe that only big-picture risk, like recessions or inflation, affects the return investors demand — and not smaller, company-specific stuff like “Will this CEO quit?” or “Will this product fail?”
🎯 The Key Concept:
In modern finance (like the CAPM), we assume:
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Some risk can be eliminated (by owning lots of stocks — diversification)
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Some risk cannot be eliminated (like recessions, interest rate hikes, etc.)
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The only risk investors should be compensated for is the risk they can’t avoid (market-wide risk)
This is how we justify using beta (market risk) in the cost of equity.
🧩 So the question is really asking:
What must we believe about the investors who are setting stock prices for this idea to make sense?
✅ The correct answer:
c. That investors who hold large stakes in the company, and trade them, are diversified.
Why?
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These are the marginal investors — the ones whose actions set stock prices.
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If they’re diversified, they don’t care about company-specific risks (because those risks cancel out in a big portfolio).
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So, only market-wide risks will matter to them — and therefore only those risks get “priced in.”
🗣 Put simply:
The market only cares about the risks that matter to the people setting prices.
And if those people don’t care about company-specific risk (because they’re diversified), then only market-wide risk gets reflected in required returns.