Taking Shots At CAPM

By Michael Schmidt AAA

When it comes to putting a risk label on securities, investors often turn to the capital asset pricing model (CAPM) to make that risk judgment. The goal of CAPM is to determine a required rate of return to justify adding an asset to an already well-diversified portfolio, considering that asset's non-diversifiable risk.

The CAPM was introduced in 1964 by John Lintner, Jack Treynor, William Sharpe and Jan Mossin. The model is an extension of the earlier work of Harry Markowitz on diversification and modern portfolio theory. William Sharpe later received a Nobel Memorial Prize in Economics along with Merton Miller and Markowitz for their further contributions to CAPM-based theory.

As said above, the CAPM takes into account the non-diversifiable market risks or beta (β) in addition the expected return of a risk-free asset. While CAPM is accepted academically, there is empirical evidence suggesting that the model is not as profound as it may have first appeared to be. Read on to learn why there seems to be a few problems with the CAPM.

Assumptions of Capital Market Theory, Markowitz-Style
The following assumptions apply to the base theory:

  • All investors are risk averse by nature
  • Investors have the same time period to evaluate information
  • There is unlimited capital to borrow at the risk-free rate of return
  • Investments can be divided into unlimited pieces and sizes
  • There are no taxes, inflation or transactions costs

Due to these premises, investors choose mean-variant efficient portfolios, which by name seek to minimize risk and maximize return for any given level of risk.

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The initial reaction to these assumptions was that they seem unrealistic; how could the outcome from this theory hold any weight using these assumptions? While the assumptions themselves can easily be the cause of failed results, implementing the model has proved difficult as well.

The CAPM Takes a Few Hits
In 1977, research conducted by Imbarine Bujang and Annuar Md Nassir poked holes in the CAPM model when they sorted stocks by earnings price characteristics. The findings were that stocks with higher earnings yields tended to have better returns than the CAPM would have predicted. More evidence mounted in the coming years (including Rolf W. Banz's work in 1981) uncovered what is now known as the size effect. Banz's study showed that small stocks as measured by market capitalization outperformed what CAPM would have expected.

While the research continues, the general underlying theme in all of the studies is that the financial ratios that analysts follow so closely actually contain some predictive information that is not completely captured in beta. After all, a stock's price is merely a discounted value of future cash flows in the form of earnings.

With so many studies attacking the validity of CAPM, why in the world would it still be so widely recognized, studied and accepted? One explanation might be in the 2004 study conducted by Peter Chung, Herb Johnson and Michael Schill on Fama and French's 1995 CAPM findings. They found that stocks with low price/book ratios are typically companies that have recently had some less-than-stellar results and may be temporarily out of favor and low in price. On the flip side, those companies with higher than market price/book ratios might be temporarily pumped up in price because they are in a growth stage.

Sorting firms on metrics like price/book or price/earnings ratios exposes investors' subjective reactions, which tend to be extremely good in good times and overly negative in bad times.

Investors also tend to over-forecast past performance, which leads to stock prices that are too high for high price/earnings firms (growth stocks) and too low for low P/E firms (value stocks). Once the cycle is complete, the results often mean higher returns for value stocks and lower returns for growth stocks.

Attempts to Replace CAPM
Attempts have been made to produce a superior pricing model. Merton's (1973) intertemporal capital asset pricing model (ICAPM), for one, is an extension of the CAPM. The ICAPM varies from CAPM with a different assumption about investor objectives. In the CAPM, investors care only about the wealth their portfolios produce at the end of the current period. In the ICAPM, investors are concerned not only with their end-of-period payoff, but also with the opportunities they will have to consume or invest the payoff.

When choosing a portfolio at time (t1), ICAPM investors consider how an investor's wealth at t (time) could differ from future variables including labor income, the prices of consumption goods and the nature of portfolio opportunities at t. But while the ICAPM was a good attempt to solve the shortcomings of CAPM, it had its limitations as well.

Conclusion
While CAPM still leads the pack as one of the most widely studied and accepted pricing models, it is not without its critics. Its assumptions have been criticized from the start as being too unrealistic for investors in the real world. Time and time again empirical studies successfully dissect the model.

Factors like size, various ratios and price momentum provide clear cases of diversion from the model's premise. This ignores too many other asset classes to be considered a viable option.

It is odd that so many studies are conducted to disprove CAPM as the standard market pricing theory, yet none to date seems to maintain the notoriety of the original one that was the theory behind a Nobel Prize.

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