By Arnold Kling
Can the Capital Asset Pricing Model be explained without using math? I don’t really think so, but I try in this essay.
Now, suppose another recipe-development project opportunity comes along. By shifting a portion of your portfolio into this new recipe-development project, you can gain the benefits of diversification. If diversification reduces your expected return, you can offset that by cutting back on your investment in risk-free securities and putting more into the “market portfolio” that combines the two recipe projects. Adding diversification to your portfolio lowers the price of risk, allowing you to have both higher returns and lower risk.
If the covariance between the two recipe projects is low, meaning that they are unlikely to both fail at once, then the diversification benefits are high, and you can shift a lot of funds out of the risk-free asset and into the market portfolio. If the covariance is high, then the diversification benefits are low, and the second recipe does not cause such a large portfolio shift.
The risk that remains in the portfolio with two assets is called market risk. There is always some market risk, because covariance is not zero, and diversification is imperfect.