Which of the following is a problem associated with the Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is built on the assumption that investors hold diversified portfolios and that specific risk can be eliminated through diversification, leaving only systematic risk or market risk. The assertion that CAPM assumes all risks are diversified away refers to the model's use of beta as a measure of a security's risk relative to the overall market. It only accounts for systematic risk, which cannot be eliminated through diversification.

When applying CAPM, it is presupposed that the investors are entirely rational and have diversified their portfolios optimally. However, in real-world scenarios, investors might not achieve complete diversification due to various constraints, including transaction costs, limited access to different asset classes, or personal investment preferences. This leads to the critique that CAPM may not fully capture the complexities of risk faced by individual investors.

Understanding this limitation helps finance professionals and investors consider other models or factors when assessing risk and expected returns, reinforcing the importance of a comprehensive approach to financial management.