Question

If the CAPM is fundamentally flawed as some argue do you think its failure is explained by irrational pricing? Or, is Beta an incomplete measure of risk?

Answer 1

Capital Asset Pricing Model or CAPM provides a measure to calculate the cost of capital of a particular security.

It says there can be two types of risks a security can be exposed to:

1) Market Risk- The risk that is faced by all the market stocks and portfolio. It is also called systematic risk and refers to those risk that cannot be minimized and is compulsory for all the investors to bear this risk and this is the reason why investors need to be paid/ compensated for bearing this risk. Beta of the CAPM model incorporates this risk which is calculated by covariance ( returns on market portfolio, returns on stock/portfolio) / variance of returns on market portfolio. Beta measures the sensitivity of a specific stock or portfolio to the market risk, if beta is 2 then the stock is twice as sensitive to the market risk and hence higher return needs to be paid in order to compensate for high beta.

2) Firm specific risk- This covers all the risks specific to individual firm and such types of risk can be averaged out to zero if the protfolio is well diversified. This is the reason why CAPM model doesn't compensate the investors to bear firm specific risk because it is not compulsory.

Now CAPM says, there are higher expected returns for larger beta values.

where expected return is calculated as,

expected return = risk free rate + beta( risk premium) , where risk premium is the difference between return on market portfolio and risk free rate.

But,recent data suggests that, stock/ portfolio returns have become less responsive to the CAPM measure of risk i.e. beta. This discrepancies occur because beta has repeatedly proved to be an incomplete measure of risk in the sense that there exist several other types of risks ( other than beta and firm specific risks) that affects the returns of the stock and which are not incorporated in the CAPM model. Studies have shown that size of the firm also affects the returns of the stock i.e. smaller firms being considered more risky by the investors offer higher returns than larger firms, also firms having high book to market value offer higher returns to investors than the firms having low book to market value.

Therefore, there are many more such risks that have significant impact in the returns of the stock/portfolio that are not considered by the CAPM model and hence the expected return calculated by the CAPM model shows some amount of deviations from the actual returns of the stock.

Irrational pricing in an effective and competitive market on the other hand may occur but cannot prevail for a long period of time because such markets are full of arbitrageurs that take advantage of such arbitrage opportuinities making them disappear in no time.

Therefore, the fundamental flaws of CAPM model exists majorly because its measure of risk, Beta, stands incomplete and doesn't incorporate all the factors affecting the rate of returns of a particular stock/ portfolio.