Limitations of CAPM 🏛️🌩️
CAPM is the most famous model in finance, but that doesn't mean it's perfect. Since its creation, many economists have pointed out that the model fails to explain how markets work in the real world.
1. Unrealistic Assumptions
As we saw in Chapter 37, CAPM relies on several "perfect" assumptions that don't exist in reality:
- Zero Transaction Costs: In the real world, brokerage and taxes eat into returns.
- Lending vs. Borrowing: CAPM assumes you can borrow money as cheaply as the Government (Rf). In reality, individuals always pay a higher interest rate than the government.
- Information Disparity: CAPM assumes everyone has the same info. In reality, some investors are much better informed than others.
2. Beta is Not Constant 📉
CAPM assumes that a stock's Beta is a stable number.
- Reality: A stock's Beta changes over time. A company might be aggressive when it's young and conservative when it grows large.
- Calculated betas differ depending on whether you use 1-year data, 5-year data, or daily vs. monthly data.
3. Roll's Critique (The Market Portfolio Problem)
The economist Richard Roll pointed out a fundamental flaw: CAPM depends on the "Market Portfolio."
- The Problem: The "True Market Portfolio" includes everything—stocks, bonds, real estate, gold, human capital, even stamps and vintage cars.
- Since we can't actually see or measure the "True Market," we use proxies like the Nifty 50 or S&P 500. Any test of CAPM is actually just a test of the index, not the theory.
4. Other Factors Matter
CAPM says only Beta matters. However, research (like the Fama-French model) shows that other factors also drive returns:
- Size: Small companies often beat large companies regardless of Beta.
- Value: "Cheap" stocks with low P/E ratios often beat "Growth" stocks.
Important
Despite these limitations, CAPM remains the "standard" because it is simple and captures the most important truth: Market risk must be rewarded.
Summary
- CAPM is a simplified model of reality.
- It suffers from restrictive assumptions and the difficulty of defining the "Market."
- Beta is not as stable as the theory suggests.
- In the next unit, we will learn how to Evaluate the actual performance of a portfolio manager to see if they are adding value.
Quiz Time! 🎯
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