CAPM is Absurd

The CAPM—the standard model upon which much of the investment industry is built—is “absurd,” according to University of Navarra Professor Pablo Fernandez, and its assumptions have “no basis in the real world.”

I am inclined to agree.

For those unversed in the language of modern finance, the CAPM—or Capital Asset Pricing Model—is a formula that calculates the required return on an investment as a function of its volatility relative to the market (“beta”).  In other words, the more volatile a security relative to the market, the higher the return you’ll require to hold it.

Every MBA finance student the world over has to learn the CAPM formula, and I could rant for days about how impractical the formula is in the real world of investing.  But let’s see what Professor Fernandez has to say on the subject.

Fernandez specifically attacks the assumptions baked into the model, namely that all investors have equal expectations of asset returns and volatility, can lend and borrow unlimited funds at the risk-free rate, can short any asset or hold fractional shares of any asset, and have identical time horizons.

Common sense would tell you that none of these assumptions are true.  Investors have wildly different views of potential returns and risks; you need both bulls and bears to make a market, after all.  Borrowing and lending at the risk-free rate (i.e. the rate the U.S. Treasury pays on its debts) is unrealistic for regular investors, to say the least.  Shorting is not always possible; it depends on the availability of shares to short. Fractional ownership of shares is not always possible, though it certainly would have been desirable.  Consider recent history when Apple (AAPL), Google (GOOG) and Berkshire Hathaway (BRK-B) all traded at share prices in the multiple hundreds or thousands of dollars.  And finally, time horizon will vary wildly from person to person based on their age and unique circumstances.

More fundamentally, I take issue with the fact that returns expectations ignore valuation altogether.  Any decent value investor knows that the returns you generate are ultimately dependent on the price you pay.

I agree with Fernandez; CAPM is absurd.  Thankfully, it is rarely used outside of academia.

Fernandez’s paper is available here.

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