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

The capital asset pricing model (CAPM) is theoretically incomplete in its demand-side focus, risk-averse investors and internally inconsistent homogeneous beliefs; is not conclusively supported empirically; and yet it legitimizes a notion that investors can earn higher returns by bearing undiversifiable risk. Our article does not merely extend the CAPM with more realistic assumptions, it completes its original framework by including (1) risk-taking investors in the investor population, (2) investors who can have heterogeneous expectations or beliefs – an overlooked but required condition for the CAPM to be an internally consistent and meaningful model of competitive financial asset pricing under uncertainty and (3) a positive-sloped short-run supply curve based on a reasonable interpretation of the nature of financial asset trade. Upon a complete economic interpretation, it is shown that the equilibrium (systematic) risk-rate of return relationship depends on whose aggregate trading activity dominates, risk-averse or risk-taking investors’. There is no universal, or even general, positive relationship between systematic risk and rate of return. This has far-reaching implications for investors and investment advisors who serve them.