4)
Investors fully diversified. The CAPM also assumes that investors are fully diversified. In practice many investors, particularly small investors, do not hold highly diversified asset portfolios.
5)
Practical data measurement problems. There are also practical problems associated with the model such as difficulties with specifying the risk-free rate, measuring beta and measuring the market risk premium.
6)
One-period time horizon. CAPM assumes investors adopt a one-period time horizon. In practice investors are likely to have differing time horizons and again this would imply varying SML’s.
7)
Single-factor model. CAPM is a single factor model: it relies on the market portfolio to explain security returns. The rate of return on a security is a function of the security beta times a risk premium, that is, β(ERM-RF). Both beta and the risk premium are determined in relation to the market portfolio. Recall that each security’s beat (risk factor) is derived by linear regression, plotting its return against the return from the market portfolio- characteristic line.
Comments and criticisms of the CAPM
Some of these assumptions are clearly unrealistic, implying that the CAPM is of very limited value. However, the model should not be dismissed solely on the grounds that it includes some simplifying assumptions. The acid test of its efficacy is : does it work? Can it be used effectively as a predictive tool? Unfortunately the evidence is controversial and inconclusive.
Some researchers have found evidence supporting the model, or certain aspects of it, and others have found evidence to challenge the model. In 1977, in what is now a classic article, Richard Roll questioned if it was even possible to test the model because it is practically impossible to establish the return on the market portfolio. As the market portfolio is theoretically supposed to include all risky assets (shares, bonds, commodities, precious metals, property, works of art, …etc) it is not feasible to test the model empirically.
Even if a stock market index is used as a surrogate for the market portfolio, this is still a very restricted view of the market portfolio as so many other types of risky assets are omitted.
On the upside, there is substantial empirical evidence supporting the positive linear relationship between an asset’s beta (risk) and its return as implied by the model (Levy and Sarnat 1994). This would apparently confirm the model’s inference that high beta (risk) shares produce high returns and low beta (risk) shares produce low returns. However, even these findings are not free from controversy.
To date perhaps the most serious challenge to validity of the CAPM has come from research by Eugene Fame and Kenneth French, both from university of Chicago, published in 1992. Fame and French found no correlation between historical betas and historical returns on over 2,000 stocks between 1963 and 1990- thus they concluded that the magnitude of a stock’s historical beta bore no relationship to the magnitude of its historical return.
Based on this, and their other findings, Fame and French concluded that ‘beta is dead’- at the time a seemingly body blow to the validity of the CAPM. Fame and French found, for example that variations in share returns had more to do with company size ( as measured by the total market value of the firm’s equity and the ratio of the company’s equity book value to its equity market value) than with beta.
Needless to say, the work of Fame and French has provoked even more controversy and many academics have since rushed to the defence of the CAPM, criticising Fame and French’s research methodology and suggesting that their arguments ‘theoretically incomplete’.
Roll and Ross (1992) , for example have argued that the use of a stock market index such as the Standard and Poor’s (S&P) 500 (a US stock market index analogous to a FTSE index in the UK), as a surrogate or proxy for the true market portfolio may not give an accurate measure of the true market returns. Thus if the surrogate portfolio used by Fame and French is not a correct one, then it may not be reasonable to conclude that there is a positive correlation between betas and rates of return.
Other researchers, such as Chan and Lakonishok (1993) have found that the CAPM is an adequate measure of the risk-return relationship.
Whatever the conclusion of various researchers, it is worth noting that all of the test of the CAPM have by necessity been based on ex post data, whereas the CAPM is an ex ante model. In other words, CAPM is a future oriented equilibrium model linking future required return and risk.
While the academic battling is likely to continue for some time, the CAPM, in the mean time, has not been dethroned. Until it is superseded by a more suitable theory the CAPM remains a valuable expectational model: it is still of value as a predictive tool.
Despite its limitations the CAPM offers the financial manager and investors a very insightful methodology for recognising and making explicit the relationship between risk and return inherent in financial decisions. If forces investors to consider both sides of the coin, not just to focus on return.
In making investment decisions, which are the key wealth- creating decisions, it is clearly important that the financial managers consider both elements, risk as well as return, in evaluating the decision. By recognising that a vital risk-return trade-off is inherent in every investment decision, and by endeavouring to take account of and evaluate risk together with return in such decisions, the financial manager will be guided towards realising the goal of shareholder wealth maximisation.
Recognising that shareholder wealth is reflected in the market price of a company’s shares, the financial managers will now realise that the company’s share price in the market will fluctuate until investors perceive that it offers a ‘fair’ return relative to its risk.
In conclusion, the CAPM is a very simple yet powerful financial model which implies that the risk premium for an individual share to the average risk premium in the stock market multiplied by the share’s price.
It is important to appreciate the CAPM’s major contribution, to our understanding of the linkages between risk and return, and how required rate of return are derived and therefore how securities are valued in the markets.
Clearly there are to be some way of analysing and relating risk to return and until a new king is crowned the CAPM will continue to rule: however the model has to be applied with care.