When labeling securities with risk, investors usually turn to the Capital Asset Pricing Model (CAPM) to make risk judgments. The goal of CAPM is to determine the required rate of return to justify adding an asset to an already fully diversified investment portfolio, while taking into account the non-diversified risks of the asset.
CAPM was developed in the early 1960s by economists John Lintner, Jack Trainor, William Sharp, and Jane Mosin.This model is an extension of Harry Markowitz’s earlier work on diversification and modern portfolio theory.William Sharp later won the Nobel Prize in Economics with Merton Miller and Markowitz in recognition of their further contributions to CAPM-based theories.
As mentioned above, in addition to the expected return of risk-free assets, CAPM also considers non-dispersible market risk or beta (β). Although CAPM is academically accepted, there is empirical evidence that the model is not as profound as it initially seems. Read on to understand why CAPM seems to have some problems.
Assumptions of capital market theory, Markowitzian
The following assumptions apply to the basic theory:
- All investors are inherently risk-averse.
- Investors have the same time to evaluate information.
- The capital borrowed at a risk-free rate of return is unlimited.
- Investments can be divided into unlimited parts and sizes.
- There are no taxes, inflation or transaction costs.
Because of these premises, investors choose an effective portfolio of mean variances. As the name suggests, it seeks to minimize risk and maximize returns at any given level of risk.
The initial reaction to these hypotheses is that they seem unrealistic; how do the results of the theory make any sense using these hypotheses? Although the assumption itself can easily be the cause of the failure of the result, it turns out that it is also difficult to implement the model.
CAPM has taken a few hits
In 1977, a research conducted by Sanjay Basu found a loophole in the CAPM model when sorting stocks according to the characteristics of return prices. The result of the survey is that stocks with higher yields tend to have better returns than CAPM predicts. In the coming years, more and more evidence (including the work of Rolf W. Banz in 1981) reveals the size effect that is now known. Banz’s research shows that small stocks measured by market capitalization outperform CAPM expectations.
Although the research continues, the basic theme of all research is that the financial ratios that analysts pay so close attention to actually contain some predictive information that is not fully captured in the beta. After all, the price of a stock is only the discounted value of future cash flows in the form of earnings.
So many studies have attacked the effectiveness of CAPM. Why is it so widely recognized, studied and accepted worldwide? One explanation may come from a study conducted by Peter Chung, Herb Johnson, and Michael Schill on the results of the Fama and French 1995 CAPM survey in 2004. They found that stocks with low price-to-book ratios are usually companies that have recently underperformed and may temporarily fall out of favor and have low prices. On the other hand, those companies that are higher than the market price-to-book ratio may temporarily increase their prices because they are in the growth stage.
Sorting companies based on indicators such as price/book value or price-to-earnings ratio exposes investors’ subjective reactions, which are often very good in good times and too negative in bad times. Investors also tend to overestimate past performance, which causes stock prices to be too high for companies with high P/E ratios (growth stocks) and too low for companies with low P/E ratios (value stocks). Once the cycle is over, the result usually means higher returns for value stocks and lower returns for growth stocks.
Try to replace the CAPM
Attempts have been made to produce good pricing models. Merton’s 1973 Intertemporal Capital Asset Pricing Model (ICAPM) is an extension of CAPM. ICAPM is different from CAPM and has different assumptions about investor goals. In CAPM, investors only care about the wealth that their portfolio generates at the end of the current period. In ICAPM, investors are not only concerned about their end-of-term earnings, but also about the opportunities they will have to consume or invest in earnings.
When choosing a portfolio at the initial point in time, ICAPM investors consider labor income, consumer product prices, and the nature of portfolio opportunities at that future point in time, and consider how the investor’s wealth at a certain point in the future is different from future variables. . However, although ICAPM is a good attempt to solve the shortcomings of CAPM, it also has its limitations.
Although CAPM is still one of the most widely studied and accepted pricing models, it is not without critics. Its assumptions have been criticized from the outset as being too unrealistic for real-world investors. Time and time again, empirical studies have successfully analyzed the model.
Factors such as size, various ratios, and price momentum provide clear examples of deviations from the premise of the model. This ignores too many other asset classes that are considered viable options.
It is strange that so many studies have been conducted to refute CAPM as the standard market pricing theory, but so far, none of the studies seems to be able to maintain the notoriety of the original theory behind the Nobel Prize.