CAPM: A Tale of Two Versions

32 Pages Posted: 8 Apr 2019

See all articles by Hammad Siddiqi

Hammad Siddiqi

University of the Sunshine Coast; University of the Sunshine Coast

Date Written: March 11, 2019

Abstract

Given that categorization is the core of cognition, we argue that investors do not view firms in isolation. Rather, they view them within a framework of categories that represent prior knowledge. This involves sorting a given firm into a category and using categorization-induced inferences to form earnings and discount-rate expectations. If earnings-aspect is categorization-relevant, then earnings estimates are refined, whereas discount-rates are confounded with the category-exemplar. The opposite happens when discount-rates are categorization relevant. Earnings-focused approach such as DCF, generally used by institutional investors, leads to a version of CAPM in which the relationship between average excess return and stock beta is flat (possibly negative). Value effect and size premium (controlling for quality) arise in this version. Discount-rate focused approach such as multiples or comparables valuation, typically used by individual investors, leads to a second version in which the relationship is strongly positive with growth stocks doing better. The two-version CAPM accounts for several recent empirical findings including fundamentally different intraday vs overnight behavior, as well as behavior on macroeconomic announcement days. Momentum is expected to be an overnight phenomenon, which is consistent with empirical findings. We argue that, perhaps, our best shot at observing classical CAPM in its full glory is a laboratory experiment with subjects who have difficulty categorizing (such as in autism spectrum disorders).

Keywords: CAPM, Categorization, Value Effect, Betting-Against-Beta, Size Effect

JEL Classification: G12, G41

Suggested Citation

Siddiqi, Hammad, CAPM: A Tale of Two Versions (March 11, 2019). Available at SSRN: https://ssrn.com/abstract=3350280 or http://dx.doi.org/10.2139/ssrn.3350280

Hammad Siddiqi (Contact Author)

University of the Sunshine Coast ( email )

Brisbane, QLD 70010
Australia
+61404900497 (Phone)

HOME PAGE: http://www.usc.edu.au/staff-repository/dr-hammad-siddiqi

University of the Sunshine Coast ( email )

90 Sippy Downs Dr
Sippy Downs QLD, Queensland 4556
Australia

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