Advantages and disadvantages of Capital Asset Pricing Model

CAPM
     Capital asset pricing model is a tool used by investors to determine the risk associated with a potential investment and also gives an idea as to what can be the expected return on the investment. It was developed by William Sharpe along with a formula for working out the risk as  who states that with an investment comes two types of risks:
1) Systematic Risk - These are risks that cannot be diversified away such as interest rates and recessions. As the market moves and changes occur which affect the market, each individual asset is affected to some degree and therefore they are sensitive to change causing a high level of risk.
2) Unsystematic (Specific) - Can be diversified through increasing the size of an investment portfolio as this risk is specific to individual stocks and effectively represents no correlation between stocks and market movements.
CAPM states that investors are compensated for taking systematic risk however not for taking specific risk as an investor can diversify this risk away. Systematic risk cannot be eliminated of course even by holding all the shares in a stock market, therefore CAPM has introduced a method of calculating that risk.

Advantages
     CAPM has been a popular model for calculating risk for over 40 years now and is therefore a proven method, some advantages are: the focus is on systematic risk as investors have diversified their portfolios, in this case unsystematic risk has effectively been eliminated. Furthermore, in the opinion of most experts it is a more reliable and effective method of calculating risk than other models such as the Dividend Growth Model as CAPM takes into account a company's level of systematic risk against the stock market as a whole; this is a benefit as it allows for a company to compare itself to the market. An investor can also use CAPM for investment appraisal as compared to other rates its offers superior discount  rates and this model also can be clearly link between required return and systematic risk.

Disadvantages
     Despite the consistent use of the model  over the years there has been some criticism for a few reasons: firstly, CAPM is based largely on assumptions and questions have been raised over the reality of the model and the results it produces. An example of this is that no market is perfect and there is no guarantee that the market has priced the assets correctly, this again makes the formula results unreliable and cannot guarantee an investor a safe investment. To add to this borrowing for investors does not come at the risk-free rate and this can mean in reality their security market line will be shallower. In terms of competition to CAPM investment appraisal offers a more long-term perception on investment return whilst CAPM is based on a a short, single-period time where it is is perceived an investment return is assumed constant over a longer time; however this has never been proven correct and is a limitation of CAPM.

     In conclusion, CAPM is a well used model for calculating risk and return on investment, its success over the last few decades shows there are definitely some big advantages to it and I personally would recommend its use for investors. However as there are clearly some limitations to the model mostly its lack of reality and shortsightedness I would also advise other models should be used to offer a range of aspects and reduce the risk for investors.