Limitations of the CAPM
7 AUG 2017
The capital asset pricing model (CAPM) is one tool investors and financial advisers use to try to determine how investments will perform and to try to price and assess them accordingly. However, like all mathematical models that seek to predict events in the real world, it suffers from some methodological limitations.
1 Portfolio Theory
CAPM has its methodological foundations in William Sharpe's portfolio theory. This theory introduced the concepts of "systemic risks" and "unsystemic" risks in market investing. Systemic risk is the risk of losing part of your investment that is inherent to the entirety of the stock market. Unsystemic risks are risks associated with a specific investment losing value. These concepts led to modern portfolio theory, which holds that sufficiently diversifying your portfolio protects you from unsystemic risks.
2 CAPM Definition
CAPM builds on the earlier portfolio theory by attempting to address systemic risks, those risks which cannot be diversified away, as well as unsystemic risks. It does this by assessing the risks of a particular stock in light of the volatility of the market as a whole. The theory rotates around an equation to assess an investment's expected return, in which the most important term of which is a factor representing how the value of an individual investment will react to a change in the rest of the market. This term is commonly referred to as "beta."
Many of the limitations to the CAPM lie in its methodological assumptions. The major components of the model's equation, the relative volatility of the investment, relies on the ability to measure the volatility of the market as a whole. This requires being able to accurately assess the volatility of every single possible investment in the market. This is not possible. Those who implement the CAPM model use a proxy, such as the S&P 500, to represent the overall volatility of the market. However, this is not the true measure the model would require to be accurate. Consequently, the model can only give approximate predictions.
4 Riskiness as Measure of Performance
The CAPM model holds that a stock's level of riskiness is the reason one stock would perform better for an investor than another stock. This means that, according to CAPM, a riskier stock, on average, will earn more money than safer stocks. The CAPM formula represents this risk factor in the beta. However, research has cast doubt on this premise. Professors Eugene Fama and Kenneth French studied share returns on the three major stock exchanges between 1963 and 1990 and found that the differences in the stocks' beta, which CAPM says should be the determinant of how much a stock makes, did not explain the returns different stocks earned for their investors.