This paper develops a theory linking expected investment returns to risk under market equilibrium. Sharpe argues that diversification makes an asset’s contribution to portfolio risk more important than its standalone volatility, establishing the framework for understanding how systematic risk should influence expected returns.
Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk
William Sharpe
Research
19 Pages
Key Takeaways
Diversification Changes Risk: With correlation below 1, combining 2 risky assets can produce portfolio volatility below the weighted volatility of the individual investments.
Correlation Matters: Sharpe illustrates diversification using correlations of 1, 0, and negative 1, showing how lower correlation increasingly bends the investment opportunity curve.
Systematic Risk Priced: Figure 8 separates total asset risk into 2 components, systematic and unsystematic, with expected returns tied to responsiveness to broader economic activity.
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