Like MPT, CAPM assumes that investors are risk-averse in the sense just described. In addition, CAPM assumes that investors have rational expectations concerning expected returns. Under this assumption, CAPM says that the expected return on an investment is equal to the risk-free rate of return plus compensation for the systematic riskof the investment in the sense just described.
The systematic riskis measured by the degree of variability of the individual investment versus the market as a whole. It relates the riskpremium associated with a particular stock (its return less the risk-free return) to that associated with the market as a whole.
That association for any stockis expressed by a number called the stock’s β (beta). Under CAPM, stocks with higher β’s are more risky than are stocks with lower β’s because they tend to swing more widely than does the market—their returns exhibit greater dispersion versus market returns.
Critique and Common Sense
On their own terms, there are several weaknesses in MPT and CAPM. First, in evaluating EMT, the need for a pricing model creates a joint hypothesis problem: No one can ever be sure in testing a model whether its failure is due to market inefficiency or to an inadequately specified asset pricing model.
Indeed, many of the anomalies in EMT mentioned earlier are attributed to deficiencies in the asset pricing model rather than to the presence of market inefficiency. These deficiencies are most often associated with imprecision in defining riskor , equivalently, in specifying β.
The joint hypothesis problem has an important implication for EMT skeptics. To disprove EMT requires proof that does not use an asset pricing model. However, any linear or nonlinear dependence in stockprice behavior is inconsistent with EMT itself. Thus, a discovery of linear or nonlinear dependence in successive stockprices (presented in the next chapter) means EMT is incomplete, period. It does not admit the alternative explanation of a “misspecified” asset pricing model.
In addition, CAPM says that expected returns from an investment are linearly related to expected returns on the portfolio of which that investment is a part. The linear relationship is given by β and is in turn dictated by CAPM’s rational-expectations assumption.
If human behavior is itself inconsistent with the rationalexpectations assumption, there is no reason to believe in such a linear relationship. This is another way of saying that the stockmar - ket is nonlinear rather than linear. In that case, β will not be an accurate measure of risk.
Finally, the rational-expectations assumption used in the CAPM requires that investors have homogeneous return expectations; this in turn requires that investors evaluate and understand information in identical ways. Heroic as that sounds, it would also require all investors to evaluate investment opportunities over identical time horizons. The patent dubiousness of these requirements recently has become an important aspect of the literature criticizing CAPM. The literature demonstrates that demand for particular stocks is sensitive to price changes, just like demand for most other goods.
Investors have different appetites for particular stocks as their prices change. Thus, markets do not depict the right price of a stock because there is no such thing. Even rational people are not homogeneous automatons; they interpret information differently, and their judgment about the present value of a business’s future cash flows will vary even if they are all rational.
As Francis Fukuyama has pointed out in another context, the neoclassical economic model of rational self-interested behavior with which EMT is ultimately linked is right only about 80% of the time.18 Its devotees forget Adam Smith, the father of their thought, who emphasized that economic life is embedded in social life and that economic actors make decisions that vary from pure economic calculus as a result of social habits and contexts. That is why in Smith’s day his field was called “political economy” rather than, as it is today, simply “economics.”
If the rest of social science should be returned to economics, it is even possible to add some physics from the hard sciences. Recall that the random walkmodel got that name because public capital markets seemed to obey the principles of Brownian motion, which specify that molecules in motion behave randomly. Although molecules lacksentience, prices are strictly creatures of the ultimate sentience, human behavior.
Common sense thus suggests that the price-molecule parallel should not hold. More powerfully, current thought in physics concerning nonlinear dynamics and chaos theory extends well beyond Brownian motion and suggests further reasons to doubt and reconsider the validity of the analogy.
The next chapter shows how that analogy has been turned upside down and inside out. Before going on, though, pause to consider whether common sense supports β as a measure of risk. What β really measures is the price volatility of a stock. If you insist on associating the word “risk” with that measure, it at most means that β captures the riskof stockprice gyrations. For a market analyst, that measurement may be of some interest.
But for a business analyst, price gyrations are useless analytic tools, and so therefore is β. What matters in business analysis might be called “business volatility,” the gyrations in earnings or cash flows a business has experienced as grounds for gauging its future business performance. The earnings and cash flows are what give a business value and what are of interest; market prices do not, and β is therefore of no interest to a business analyst.
As the vogue of mathematical investing approaches raged in the late 1960s, Ben Graham declared that treating volatility in price changes as the meaning of riskis “more harmful than useful for sound investment decisions because it places too much emphasis on market fluctuations.” EMT sought to neutralize that objection by saying that market fluctuations were simply rational price changes reflecting information changes. Just so. Yet some things are not that simple. Charlie Munger is fond of quoting Einstein on this point: Everything should be made as simple as possible, but no more so. Graham continues to be right.
Read More : The Capital Asset Pricing Model
