Comments to the Paper 'CAPM: An Absurd Model'
29 Pages Posted: 4 Nov 2014
Date Written: November 3, 2014
On October 2014, I sent the article “CAPM: an absurd model” to several professors, professionals and Ph.D. students, telling them that “I will appreciate very much your opinion and criticism”. I thank very much all that answered the about 300 interesting comments and criticism that follow. I have learned a lot reading (and thinking about) all of them because are real opinions of real persons that know finance and have thought about it.
The CAPM is about expected return. If you find a formula that works well in the real markets, would you publish it? Before or after becoming a billionaire?
The CAPM is an absurd model because not only its assumptions but also its predictions/conclusions have no basis in the real world. (Absurd means: ridiculously unreasonable, unsound, or incongruous; having no rational or orderly relationship to human life. Meaningless. utterly or obviously senseless, illogical, or untrue; contrary to all reason or common sense; laughably foolish or false.)
With the vast amount of information and research that we have, it is quite clear that the CAPM is neither a theory nor a model because it does not “explain facts or events”, nor does it “describe the past, present, or future state of something”.
The use of CAPM is also a source of litigation. Users of the CAPM make many illogical errors valuing companies, accepting/rejecting investment projects, evaluating fund performance, pricing goods and services in regulated markets, calculating value creation…
We may find out an investor’s expected return for IBM by asking him. However, it is impossible to determine the expected return for IBM of the market, because this parameter does not exist. Different investors have different cash flow expectations and different expected (and required) returns to equity. One could only talk of the expected return of the market if all investors had the same expectations. But investors do not have homogeneous expectations.
Valuation is about required return. There are persons, papers and books that mix (or assume that are equal) expected and required returns.
Keywords: CAPM; Expected beta; historical beta; required beta; Expected Market Risk Premium; Required Market Risk Premium; Expected Return to Equity; Required Return to Equity; Company Valuation
JEL Classification: G12, G31, G32
Suggested Citation: Suggested Citation