The Capital Asset Pricing model and its successors……useful or useless?

Capital market theory is an integral part of an investor’s decision making process and this is overtly evident in the popular use of the Capital Asset Pricing Model or CAPM. The CAPM has been the most prolific theory in its field for the last forty years with its creator Professor William Sharpe receiving the Noble prize in economics in 1990. Following on from last blog posting the CAPM is a financial model that seeks to further develop an explanation of the relationship between risk and return. It provides investors with what they crave, through a logical and common sense approach, a trade-off between risk and return that gives a consistency to risk premiums. However of late, the CAPM and its primary successor the Arbitrage Pricing Theory are now considered to encompass a more traditional set of theories. Indeed both lack empirical academic support and rely upon some very strict assumptions that are not routinely found in financial markets. Both CAPM and APT form a very specialised branch of portfolio theory that while highly useful through the insights they provide are too flawed to be used on their own. The dynamism and evolving nature of financial markets has meant that these theories have been resigned to playing a lessor role to more modern financial models such as Tonis Vaga’s Coherent Market Hypothesis. With its multiple detractors the CAPM has received widespread criticism throughout the years, primarily linked to the inaccuracy of its component parts thus consequently I hope to clarify its shortcomings while acknowledging what it still offers a modern investor.

 

CAPM

   

Essentially CAPM epitomizes a reductionists approach to the understanding of the basic market mechanics. It is an equilibrium model that provides a snapshot of the market at any given time. In order to do this it must isolate three key components, the risk free rate, the beta and the expected market return. By manipulating and equating these inputs through the formula one can theoretically determine the required rate of return of an asset in a well-diversified portfolio. Its logical appeal is evident when the results of the model graphically represented in the form of the Security Market Line. It sheds light on the relationship between the beta and the required return of the asset in question.

The slope of this line represents the market risk premium required by investors and in a perfectly efficient market assets would be placed somewhere along this line. According to the model if an assets expected return in relation to its risk is plotted above the line then it is said to be undervalued. By undervalued I am referring to the fact that an investor could expect a larger return for the inherent risk it is exposed to. Similarly the opposite would apply for an asset that was plotted below the SML and thus, as dictated by CAPM, overvalued.

However by isolating these components, the CAPM makes numerous and contentious assumptions about investors and the market, not to mention the accuracy of its inputs. Of investors the model assumes that all active participants are rational, risk averse and utility maxi misers with homogenous expectations and requirements. This is certainly not the case in reality, if we were to hold these assumptions as true then the markets would consistently enter a pattern of boom and systemic destruction over the course of time. It is precisely the fact that independent investors hold opposing views enables a financial market to operate as per the zero sum hypothesis. Even the volatility of late and the massive slump witnessed across financial markets in 2008 still fall under the realm of stable market operation in relative terms. The simple rational investors that traditional theories chose to rely upon are ideal actors that do not represent the complexities of investor behaviour. Differing investment goals bring about varying investment strategies that span the entire market spectrum, utilising numerous asset classes. For instance everyone investor who shorts an equity on the back of a recent development, a strategy often employed by day traders, there are those such as institutional investors who are prepared to weather the storm and hold a long term position. Equally the amount of resources available to investors differs hugely and can play a major role in determining risk appetite. Quite simply an investor with ample resources can afford to take on additional risk and the potential for financial loss that goes with it.

 Of the markets it assumes that tax or transaction costs do not exist and that all information pertaining to the market is freely available to every investor all the time. Information costs mean that investors must do with varying levels and quality of information in the course. It also ignores the fact that some securities are not easily divisible and that the standard deviation of past returns may not necessarily provide a solid base for future risk assessment.