Applying the CAPM: budgeting, security selection and portfolio building

In short

• The CAPM return is the usual first estimate of the required return for valuing assets and for capital budgeting (discount rate in NPV), also for regulated companies' cost of capital and fair insurance premiums.
• The security characteristic line (SCL) plots $R_i - R_f$ against $R_m - R_f$: intercept = Jensen's alpha, slope = beta.
• With heterogeneous beliefs, a forecast return above the SML (positive alpha) means undervalued: buy. Below the SML means overvalued: avoid or short.
• Add securities with positive alpha, drop or underweight those with negative alpha. Weight each in proportion to $\alpha_i/\sigma_{e_i}^2$: more alpha, more weight; more nonsystematic risk, less weight.
• The information ratio $\alpha_i/\sigma_{e_i}$ is abnormal return per unit of nonsystematic risk added. About 30 randomly chosen securities remove most nonsystematic risk.