The Foundations of Modern Investing: Why Markowitz and the CAPM Still Matter
Have you ever wondered how professional investors decide which mix of investments to hold in a portfolio? Or how they figure out what a ‘fair’ return is for taking on risk?
These ideas trace back to two of the most influential financial theories of the 20th century:
Modern Portfolio Theory (MPT), developed by Harry Markowitz in the 1950s
The Capital Asset Pricing Model (CAPM), introduced by William Sharpe in the 1960s
These models don’t claim to predict the future. Instead, they offer a framework to help investors think clearly about risk, return, and the trade-offs involved in constructing a portfolio.
Let’s explore what they say—first in plain English, then with optional formulas for those who want to dig slightly deeper.
Part 1: Markowitz and Modern Portfolio Theory (MPT)
The Big Idea
Markowitz shows that investors shouldn’t just pick individual investments that look good in isolation. Instead, they should look at how the pieces fit together in a portfolio.
Why? Because risk isn’t just about how bumpy an investment’s ride is—it’s about how much it bumps around in relation to everything else you own.
What Is Risk?
In investing, risk is usually measured by volatility—how much returns tend to fluctuate over time. Typically, this is done via standard deviation. An investment that jumps up and down a lot is considered riskier than one that moves more steadily.
But when we combine multiple investments, we care about how they move together. This is captured by correlation. If two investments don’t move in sync, they can smooth each other out.
Example: Two Risky Assets, Less Risk Together
Suppose we’re choosing between two investments:
Investment A: Expected return = 8%, volatility = 15%
Investment B: Expected return = 12%, volatility = 20%
Correlation between A and B = 0.3
If we put 50% in each, we get:
Expected portfolio return = (0.5 × 8%) + (0.5 × 12%) = 10%
Portfolio volatility ≈ 14.2% (less than the average of 15% and 20%)
Even though both investments are risky, combining them reduces the overall risk. In fact, combining them is less ‘risky’ than holding either individual investment. That’s diversification in action.
For those interested: The maths behind portfolio return and risk
Expected return of a portfolio:
E(Rp) = w1 × E(R1) + w2 × E(R2) + … + wn × E(Rn)
Portfolio variance (σ²):
σ²p = w1² × σ1² + w2² × σ2² + 2 × w1 × w2 × Corr(1,2) × σ1 × σ2
Where:
w = weight in portfolio
n = number of investments
σ = volatility (standard deviation)
Corr(1,2) = correlation between assets 1 and 2
Part 2: The Capital Asset Pricing Model (CAPM)
The Big Idea
CAPM builds on portfolio theory by asking: how much return should an investor expect from a risky investment?
It says that investors should only be compensated for the kind of risk that cannot be diversified away—known as systematic risk, or market risk.
Since unsystematic risk can be diversified away, rational investors won’t require extra return (i.e. a risk premium) to bear it. Why?
Because:
Any investor can reduce unsystematic risk to nearly zero simply by diversifying.
Therefore, in a competitive market, investors won’t be paid extra to hold it — if they were, others would rush in, arbitraging away the opportunity.
Systematic risk is measured using beta (β).
If beta = 1, the investment moves in line with the market.
If beta > 1, it’s more volatile than the market.
If beta < 1, it moves less than the market.
If beta = 0, it’s unrelated to the market.
The market portfolio always has a beta of 1 by definition.
Example: What return should I demand?
Suppose:
Risk-free rate = 3%
Expected return of the market = 9%
Stock ABC has a beta of 1.5
Then, according to CAPM:
Expected return = 3% + 1.5 × (9% − 3%)
Expected return = 3% + 9% = 12%
So, investors should only buy Stock ABC if they expect a return of at least 12%, to compensate for its higher risk than the market.
For those interested: The CAPM formula
Expected return = Rf + β × (Rm − Rf)
Where:
Rf = risk-free rate
Rm = expected return of the market
β = beta of the investment
Beta itself is calculated as:
β = Cov(Ri, Rm) / Var(Rm)
That is, the investment’s return covariance with the market, divided by the variance of market returns.
Strengths of These Models
Limitations in Practice
What Should Investors Take Away?
Diversification works – combining assets can reduce risk without sacrificing return.
Focus on market risk – you should only expect extra return for taking risk that can’t be diversified away.
Models are tools, not oracles – they help you think clearly about risk and return, but shouldn’t be followed blindly. MPT and the CAPM have been built upon extensively and should not be used in isolation.
References
Bodie, Zvi, Alex Kane, and Alan J. Marcus. 2014. Investments. 10th ed. New York: McGraw-Hill Education.
Fama, Eugene F., and Kenneth R. French. 1992. ‘The Cross‐Section of Expected Stock Returns’. Journal of Finance 47 (2): 427–65. https://doi.org/10.1111/j.1540-6261.1992.tb04398.x
Markowitz, Harry. 1952. ‘Portfolio Selection’. Journal of Finance 7 (1): 77–91. https://doi.org/10.2307/2975974
Sharpe, William F. 1964. ‘Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk’. Journal of Finance 19 (3): 425–42. https://doi.org/10.2307/2977928