The model assumes an investor who considers that most securities are priced efficiently, but who believes they have information that can be used to predict the abnormal performance (Alpha) of a few of them; the model finds the optimum portfolio to hold under such conditions.
In the active portfolio the weight of each stock is proportional to the alpha value divided by the variance of the residual risk.
Assume that the risk-free rate is RF and the expected market return is RM with standard deviation
There are N securities that have been analyzed and are thought to be mispriced, with expected returns given by: where the random terms
This is often regarded as the major flaw of the model, as it often yields an unrealistic weight in the active portfolio.