The risk of a portfolio is comprised of systematic risk and specific risk. Specific risk is the risk associated with individual assets. Systematic risk refers to the risk common to all securities. CAPM considers the market portfolio (the value-weighted portfolio comprising every asset) as the optimal portfolio. The beta of a stock or a portfolio (e.g. mutual fund) measures its sensitivity to the movement of the broader market. Betas exceeding one signify more than average riskiness, stock market index has a beta of one. Most of mutual funds portfolios have systematic risk smaller than one.
According to the CAPM a the required rate of return of a stock is derived by:
rs = β ( rm - rf ) + rf
rs is the required rate of return on a stock rm is the market rate of return rf is the interest rate">risk free interest rate β is the beta of the stock
Does not edequately explain the variation in stock returns. Market portfolio and its return are unobservable and have to be estimated, therefore the model is not testable.