The Nobel Prize-Winning Model That Explains Why You Get Paid for Risk

The Capital Asset Pricing Model (CAPM), created by William Sharpe in the 1960s (who won a Nobel Prize for it), looks complicated, but its components offer profound insights into retirement planning. We aren't going to use it to price assets today; instead, we're going to look at three things about retirement by using the logic of the CAPM.

Today, we'll break down how to deal with unexpected investment outcomes, the fundamental risk/return trade-off, and the one mistake you must never make. You can follow along in my YouTube video here and see this formula in action.

1. The Power of Low Expectations

The first term in the CAPM formula is Expected Return. The most powerful asset an investor can have is realistic, or even low, expectations. As Warren Buffett and Charlie Munger often joked, lowering expectations is how they achieved great success.

The Problem of Exponential Growth

When you're young, a 20% portfolio loss is minor. But, close to retirement, a 20% loss can equal more than the cost of your first house. This rapid, exponential growth of wealth near retirement is unnatural to humans, who tend to think linearly.

Because it's so easy to say the "right things" about market resilience—like "Time in the market beats timing the market"—but much harder to live through, you must prepare mentally. If you don't prepare yourself mentally for a loss of seven figures, you are at high risk of making an emotional decision that will permanently damage your retirement.

2. The Fundamental Risk-Free Trade-Off

The second term in the CAPM formula is the Risk-Free Rate (in the U.S., currently defined by the Fed funds rate). In order to be successful in retirement, your assets must at least achieve this rate; otherwise, your wealth will slowly melt away due to inflation.

The Trade-Off

The biggest mistake you can make is not defining the return rate that will allow you to achieve your goals. You have to decide: Do I only need to earn the risk-free rate, or do I need to earn more?

You must determine your position on the risk continuum:

• Zero Beta (0% Risky Assets): You have all your money in risk-free assets. This avoids market volatility but exposes you to inflation risk.

• Beta of One (100% Risky Assets): Your portfolio fully participates in the stock market.

• The Biggest Mistake: Not having a proper framework for your risk exposure. If you are taking too much risk without a clear reason, you open yourself up to making an emotional mistake (selling at the wrong time) during inevitable market downturns.

3. Understanding What You're Paid For: Beta vs. Alpha

The final component of CAPM explains why you get paid for risk.

• Beta Risk (Compensated): This is the risk of investing in the broad market (like the S&P 500). Because the stock market is volatile and experiences regular 20% dips, you are compensated with an Equity Risk Premium for enduring that volatility. This is the only type of risk compensated for under the CAPM framework.

• Alpha Risk (Uncompensated): This is idiosyncratic risk (company-specific risk). This risk is associated with the chance that a single company will be disrupted, fail, or underperform its market. The CAPM model suggests you should not expect to be compensated for taking this kind of specific risk.

The Active vs. Passive Decision

When you invest in actively managed funds that claim to find "high quality equities" that will outperform the market, you are betting on their ability to deliver Alpha. Conversely, if you choose passively managed index funds, you are betting on receiving the market's average Beta return.

For most investors, the easiest way to ensure you are compensated for the risk you take is to maintain a broadly diversified portfolio that captures the market's Beta return, rather than chasing company-specific Alpha.

At Barrett FP LLC, we offer expert financial planning on an hourly basis, focused entirely on helping you achieve your goals.

Learn more about how we can help you build an objective, data-driven investment plan.