Alternatives TOWARDS THE CAPM 1


The Capital Asset Pricing Model (CAPM) is nearly fifty years of age and it still evokes strong responses, especially from practitioners. In academia, the CAPM lives on primarily in the archives of old journals & most researchers have moved on to newer asset pricing models. To practitioners, it represents anything that is incorrect with financial theory, and beta is the cudgel that is utilized to take down academics, no matter what the topic.

The CAPM is a flawed model for risk and come back among many flawed models. The estimates of expected return that people get from the CAPM can be significantly improved if we use more info and remember basic statistics along the way. In fact, getting rid of the CAPM from my tool container will in no real way paralyze me in my estimation of value.

Notwithstanding this, I understand the discomfort that people feel with the CAPM at several levels. First, by you start with the premise that risk is symmetric – the upside and downside are balanced – it already seems to concede the fight to beat the market. After all, a good investment should have more upside than drawback; value investors in particular build their investment strategies around the ethos of minimizing downside risk while expanding upside potential.

Second, the model’s dependence upon previous market prices to get a measure of risk (betas in the end come from regressions) should make anyone wary: in the end, marketplaces are often volatile for no good fundamental reason. Third, the CAPM’s concentrate on wearing down risk into diversifiable and undiversifiable risk, with only the latter being relevant for beta will not convince some, who believe that the distinction is meaningless or should not be made.

Consequently, both academics and professionals have been on the lookout for better ways of measuring risk and estimating expected comes back. Remember that in this create, the riskfree rate and expected risk premium are the same for any investments in a market which beta alone carries the responsibility of measuring risk.

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The fact that betas are scaled around one offers a simple intuitive hook: an investment with a beta of just one 1.2 is 1.2 times more dangerous than the common investment on the market. I have extended papers about how best to estimate the riskfree rate and expected equity risk premium.

Contrary to conventional wisdom, which views theorists as cult fans of beta, the criticism of the CAPM in academia has been around for so long as the model itself. The Arbitrage Pricing Model, which stays true to conventional portfolio theory, but allows for multiple (though unidentified) sources of market risk, with betas estimated against each one.

Both models signify extensions of the CAPM, with multiple betas replacing a single market beta, with risk monthly premiums to go with each one. Pluses: Do much better than the CAPM in detailing past return variations across investments. Minuses: For forward looking estimates (which is exactly what we usually need in commercial financing and valuation), the improvement within the CAPM is debatable. Important thing: If you don’t like the CAPM due to its complexity and its own assumptions about markets, you will like multi beta models less even.