Question

When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein: Book Question: How does the author’s process and recommendation compare to academic theories like the efficient market hypothesis or capital asset pricing model,

Answer 1

The author's process and recommendation are compared to academic theories in the book. Efficient market hypothesis refers that share prices reflect all relevant information, and that it is impossible to beat the market or achieve above-average returns on a sustainable basis. There are many critics of this theory, such as behavioral economists, who believe in inherent market inefficiencies.

The Capital Asset Pricing Model (CAPM) states the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securitiesand generating expected returns for assets given the risk of those assets and cost of capital.

The formula for calculating the expected return of an asset given its risk is as follows:

ER_i = Expected return of investment

R_f = Risk-free rate

β_i = Beta of the investment

ER_m = Expected return of market

(ER_m - R_f) = Market risk premium

Investors expect to be compensated for risk and the time value of money. The risk-free ratein the CAPM formula accounts for the time value of money. The other components of the CAPM formula account for the investor taking on additional risk.

The academic theories suggest that the goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and the time value of money are compared to its expected return.