Why capm is not perfect

Exhibit II graphically illustrates the reduction of risk as securities are added to a portfolio. Empirical studies have demonstrated that unsystematic risk can be virtually eliminated in portfolios of 30 to 40 randomly selected stocks. Of course, if investments are made in closely related industries, more securities are required to eradicate unsystematic risk. Exhibit II Reduction of unsystematic risk through diversification. The investors inhabiting this hypothetical world are assumed to be risk averse.

This notion, which agrees for once with the world most of us know, implies that investors demand compensation for taking on risk. In financial markets dominated by risk-averse investors, higher-risk securities are priced to yield higher expected returns than lower-risk securities. A simple equation expresses the resulting positive relationship between risk and return.

The expected return on a risky security, R s , can be thought of as the risk-free rate, R f , plus a premium for risk:. These assumptions and the risk-reducing efficacy of diversification lead to an idealized financial market in which, to minimize risk, CAPM investors hold highly diversified portfolios that are sensitive only to market-related risk.

Since investors can eliminate company-specific risk simply by properly diversifying portfolios, they are not compensated for bearing unsystematic risk. Thus an investor is rewarded with higher expected returns for bearing only market-related risk. This important result may seem inconsistent with empirical evidence that, despite low-cost diversification vehicles such as mutual funds, most investors do not hold adequately diversified portfolios.

These actively trading investors determine securities prices and expected returns. If their portfolios are well diversified, their actions may result in market pricing consistent with the CAPM prediction that only systematic risk matters. Beta is the standard CAPM measure of systematic risk. It gauges the tendency of the return of a security to move in parallel with the return of the stock market as a whole.

A stock with a beta of 1. Stocks with a beta greater than 1. Conversely, a stock with a beta less than 1. Securities are priced such that:. I have illustrated it graphically in Exhibit III. As I indicated before, the expected return on a security generally equals the risk-free rate plus a risk premium. In CAPM the risk premium is measured as beta times the expected return on the market minus the risk-free rate. The risk premium of a security is a function of the risk premium on the market, R m — R f , and varies directly with the level of beta.

No measure of unsystematic risk appears in the risk premium, of course, for in the world of CAPM diversification has eliminated it. In the freely competitive financial markets described by CAPM, no security can sell for long at prices low enough to yield more than its appropriate return on the SML. The security would then be very attractive compared with other securities of similar risk, and investors would bid its price up until its expected return fell to the appropriate position on the SML.

Conversely, investors would sell off any stock selling at a price high enough to put its expected return below its appropriate position. An arbitrage pricing adjustment mechanism alone may be sufficient to justify the SML relationship with less restrictive assumptions than the traditional CAPM.

One perhaps counterintuitive aspect of CAPM involves a stock exhibiting great total risk but very little systematic risk. An example might be a company in the very chancy business of exploring for precious metals.

Viewed in isolation the company would appear very risky, but most of its total risk is unsystematic and can be diversified away. The well-diversified CAPM investor would view the stock as a low-risk security.

In practice, such counterintuitive examples are rare; most companies with high total risk also have high betas and vice versa. Systematic risk as measured by beta usually coincides with intuitive judgments of risk for particular stocks.

There is no total risk equivalent to the SML, however, for pricing securities and determining expected returns in financial markets where investors are free to diversify their holdings. Let me summarize the conceptual components of CAPM. According to the model, financial markets care only about systematic risk and price securities such that expected returns lie along the security market line. Its use in this field has advanced to a level of sophistication far beyond the scope of this introductory exposition.

CAPM has an important application in corporate finance as well. In theory, the company must earn this cost on the equity-financed portion of its investments or its stock price will fall. If the company does not expect to earn at least the cost of equity, it should return the funds to the shareholders, who can earn this expected return on other securities at the same risk level in the financial marketplace.

Since the cost of equity involves market expectations, it is very difficult to measure; few techniques are available. This difficulty is unfortunate in view of the role of equity costs in vital tasks such as capital budgeting evaluation and the valuation of possible acquisitions.

The cost of equity is one component of the weighted average cost of capital, which corporate executives often use as a hurdle rate in evaluating investments. Financial managers can employ CAPM to obtain an estimate of the cost of equity capital. If CAPM correctly describes market behavior, the security market line gives the expected return on a stock. Over the past 50 years, the T-bill rate the risk-free rate has approximately equaled the annual inflation rate. Along with these specific technical recommendations, I want to close with some general analysis advice.

By necessity, this is even more vague than my preceding suggestions. Many bad capital-budgeting inputs and outputs occur because someone you?

If your input estimates come from someone who has a conflict of interest, do not trust them. Estimates from employees, lawyers, investment bankers, and so forth are rarely unbiased.

Solicit advice from various parties, ideally ones with opposite motives. And be warned: You may not like what you hear. We are all overly optimistic, but admitting we have a problem is the first step to recovery. The most important factor, and perhaps the most obvious, is forgetting the realistic probability of utter failure and so incorrectly judging the most likely outcomes.

For each 1 percent probability that a pandemic, earthquake, fire, plane crash, or employee death will wipe out entire projects, the internal rate of return for the project will be 1 percent lower.

Recognizing common human biases can sometimes justify conservatively increasing project investment hurdle rates to exceed the CC. Many managers, especially pessimistic ones, like scenario analyses which help them incorporate potential failures into their estimates.

I am skeptical about the usefulness of these analyses for CC assessments, though not for expected cash flow assessments. I do not know of a way to effectively use bad scenarios in a formal decision process. Humility: CC assessments for non-trivial projects have low accuracy.

Except for fixed-income investments, the most important prescription for assessing the CC may well be humility—a quality that does not come easily to either practitioners or finance professors.

Even the best CC estimates are rough. It may be better to adopt a pessimistic view than the average one. While students often believe that theory is more difficult than practice, unfortunately, the opposite is true.

To many managers who already have an intuitive understanding of their own ignorance, the flaws in the CAPM may not be news. Such managers tend to err on the side of caution. So even firms with abundant access to capital may prefer to forgo many profitable projects. I close with the observation that, while students often believe that theory is more difficult than practice, unfortunately, the opposite is true.

Mathematically, a capital structure with more leverage has a higher cost of debt and a higher cost of equity but tilts the weighting from higher-cost equity towards lower-cost debt. Of course, the Modigliani-Miller world is primarily a thought experiment. When the capital markets are not perfect, firms can minimize their WACC by choosing the best capital structure—the one that minimizes their tax obligation, moral hazard and agency conflicts, adverse information disclosure, transaction costs, etc.

This works because WACC tends to be very insensitive to modest levels of leverage. Put differently, it matters little whether a firm chooses a capital structure of 10 percent debt or 30 percent debt; the WACC typically remains about the same. Fine-tuning their optimal choice of leverage really matters only for firms that are high-leverage say, 80 percent or more , such as financial services firms, firms near financial distress, or firms in leveraged buyouts.

As shown in Figure B above, the empirical evidence for large publicly traded firms suggests that the expected rate of return on equity does not increase with market-beta and leverage. What does this imply to an enlightened manager about optimal capital-structure and WACC? Of the three effects of leverage higher CC on debt, higher CC on equity, more weight on the debt component only the first and last remain. The WACC then decreases as long as the expected rate of return on marginal debt remains below the expected rate of return on equity.

Managers can thus obtain the lowest WACC with a capital structure in which the expected rate of return on debt is equal to the roughly constant expected rate of return on equity on the margin.

The average cost of capital on debt should be lower. To the extent that managers care only about equity returns if only because debt default could get them fired , and if the debt comes from external capital providers and not from the equity holders themselves , they can follow an even simpler rule. They can compare the quoted interest rate on debt to the expected rate of return on equity, and use debt financing until the two become equal. If they pursue this capital structure policy, then all three rates are the same: the CC for capital budgeting purposes, the quoted rate of return on debt, and the expected rate of return on equity.

This equal cost of equity capital structure theory has clear flaws, but it may be more realistic and useful than its competitors. The evidence will tell. Ivo Welch is the J. His published work has been highly influential both in finance and economics. His current research agenda focuses on the estimation and uses of market-beta.

All Rights Reserved. Sign in. Forgot your password? Password recovery. Recover your password. Get help. Friday, November 12, Log In. Winter Issue Winter Articles. Praise for MBR. A holding period of one year is usually used. This is an assumption made by portfolio theory, from which the CAPM was developed, and provides a minimum level of return required by investors.

The risk-free rate of return corresponds to the intersection of the security market line SML and the y-axis see Figure 1. This assumption means that all securities are valued correctly and that their returns will plot on to the SML.

A perfect capital market requires the following: that there are no taxes or transaction costs; that perfect information is freely available to all investors who, as a result, have the same expectations; that all investors are risk averse, rational and desire to maximise their own utility; and that there are a large number of buyers and sellers in the market.

While the assumptions made by the CAPM allow it to focus on the relationship between return and systematic risk, the idealised world created by the assumptions is not the same as the real world in which investment decisions are made by companies and individuals.

Real-world capital markets are clearly not perfect, for example. Even though it can be argued that well-developed stock markets do, in practice, exhibit a high degree of efficiency, there is scope for stock market securities to be priced incorrectly and so for their returns not to plot onto the SML.

The assumption of a single-period transaction horizon appears reasonable from a real-world perspective, because even though many investors hold securities for much longer than one year, returns on securities are usually quoted on an annual basis.

The assumption that investors hold diversified portfolios means that all investors want to hold a portfolio that reflects the stock market as a whole. Assuming that investors are concerned only with receiving financial compensation for systematic risk seems therefore to be quite reasonable. A more serious problem is that investors cannot in the real world borrow at the risk-free rate for which the yield on short-dated government debt is taken as a proxy.

The reason for this is that the risk associated with individual investors is much higher than that associated with the government. This inability to borrow at the risk-free rate means that in practice the slope of the SML is shallower than in theory. Overall, it seems reasonable to conclude that while the assumptions of the CAPM represent an idealised world rather than the real-world, there is a strong possibility, in the real world, of a linear relationship between required return and systematic risk.

The weighted average cost of capital WACC can be used as the discount rate in investment appraisal provided that some restrictive assumptions are met. These assumptions are as follows:.

These assumptions are essentially saying that WACC can be used as the discount rate provided that the investment project does not change either the business risk or the financial risk of the investing organisation. If the business risk of the investment project is different to that of the investing organisation, the CAPM can be used to calculate a project-specific discount rate.

They are more risky and give a higher return than the market average. The scrips with a low Beta are defensive and have lower returns but are less risky than the market average like ITC or Hindustan Lever. Thus the portfolio theory and portfolio management constitute the rational ground to base the purchases and sales of the investor. The fundamental factors of financial and physical performance of the company provide the basis for the forecast of the prices of shares.

The technical analysis of the market helps the determination of time for purchase or sale. All those together constitute the theoretical framework for investment analysis and market operations.

The choice of a portfolio aims at reducing the risks which are broadly of two categories, namely, systematic risk and unsystematic risk. The examples are changes in economic conditions, interest rate changes, inflation, recession, changes in the market demand, etc. These risks are classified as interest rate risk, purchasing power risk inflation and market risk. The unsystematic risk is the controllable variation in earnings due to the peculiar characteristics of the industry, and company management efficiency, consumer preferences, labour problems, raw material problems, etc.

These are classified as business risks, financial risks, etc. The total risk is defined as the total variability of returns, which is the summation of systematic and unsystematic risks and component of residual factors, which cannot be explained and accounted for. For a scientific basis for investment, the analyst or investor has to make a rational analysis of the market and the scrips in which he would like to invest.

For this purpose, he should be familiar with factors that influence the market prices and the rationale of price formation. One should ask, what determines the prices? Why is the present price of a scrip of Telco at Rs. Why is Tisco scrip quoted at Rs. Is it overpriced or underpriced? Is it worth buying at this level or not? These and other questions should be analysed and understood by the investor and trader. The theoretical basis for this price formation is, therefore, important.

Capital assets pricing model is the model tested under Capital Market Theory. This model helps the investor build his portfolio of assets through the use of Beta. Although it is theoretical, the practical application of this is the use of market Beta and individual scrip Betas to select the scrips suitable to the preferences of investors, so that the returns are maximised for the given level of risk. The CAPM has serious limitations in real world, as most of the assumptions, are unrealistic.

Many investors do not diversify in a planned manner. Besides, Beta coefficient is unstable, varying from period to period depending upon the method of compilation. They may not be reflective of the true risk involved. Due to the unstable nature of Beta it may not reflect the future volatility of returns, although it is based on the Past history.

Historical evidence of the tests of Betas showed that they are unstable and that they are not good estimates of future risk. But the Batas of a portfolio may be stable. Besides the relation between risk and return is linear.

Although CAPM focuses attention on market related risk systematic risk , total Risk has been found to be more relevant and both types of risk appear to be positively related to the returns. Another limitation is that investors do not seem to follow the postulation of CAPM although this does not invalidate the theory as such. The analysis of SML is also not applicable to the bond analysis, although bonds are a part of a portfolio of investors.

The factors influencing bonds in respect of risk and return are different and the risk of bonds is rated and known to investors. The conceptual nicety of CAPM is thus broken by the less practical nature of this model and complexity and difficulty of dealing with the Beta values. Lastly, the fact that Betas may not reflect the total risk of the security but only systematic risk is another limitation of CAPM. The investors prefer more wealth to less wealth.

Their happiness in having wealth is measured by utility or in other words some subjective index of preferences. It is assumed here that the utility is measurable by a numerical number and the one with a higher numerical value is preferred to one with a lower numerical value under conditions of certainty, the utility function is known and the investor preference for higher utility as compared to that of lower utility is the national behaviour of investor.