Explain how the CAPM development effectively makes use of the diversification as a foundation for the development of the model.

Capital Asset Pricing Models (CAPMs) were developed to measure and better understand risk-return relationships in investment. The model relies heavily on diversification – the concept of spreading investments over different economic sectors or asset classes to lower overall risks. The theory states that investors can get higher returns and lower risk by investing in more than one asset. This is because they are less exposed to market fluctuations.

The CAPM takes this concept of diversification further by introducing the idea of “market portfolio” which consists of all possible investment opportunities available within a given market. It is based on the idea that by creating an optimal portfolio of all available options, investors will be able to maximize their potential return at a particular level risk. This model effectively uses the diversification concept as its basis by allowing investors select assets with higher expected returns than would be available from just investing in one stock or bond, without needing to take on excessive levels of risk.