All the above lessons from multifactor models are similar to the lessons from the CAPM.

The average investor holds the market portfolio. Under both CAPM and multifactor models, the average investor holds the market.

Exposure to factor risk must be rewarded. Under CAPM assumptions, the market factor is priced in equilibrium. However, under multifactor models, risk premiums exist for each factor, assuming no arbitrage or equilibrium.

Diversification of idiosyncratic risks works. In CAPM, the market diversifies away the idiosyncratic risk. In multifactor models, the tradeable version of a factor diversifies the idiosyncratic risk.

Things to Remember

• Capital Asset Pricing Model (CAPM) is a model that describes the relationship between systematic risk and expected return for assets, particularly stocks.
• Multifactor models are extensions of the CAPM that incorporate multiple sources of risk or factors that can affect asset returns.
• Factor models help in understanding the drivers of asset returns and in pricing assets based on their exposure to these factors.
• Factors in multifactor models can include macroeconomic variables, industry-specific factors, or other sources of risk that can impact asset returns.
• Investors can use multifactor models to better understand the risk-return tradeoff of their portfolios and to make more informed investment decisions.