CAPM is CRAP, or, The Dead Parrot lives.docVIP

CAPM is CRAP, or, The Dead Parrot lives!By James Montier Is C(apital) A(sset) P(ricing) M(odel) C(ompletely)R(edundant) A(sset) P(ricing)? The capital asset pricing model (CAPM) is insidious. It creeps into almost every discussion on finance. For instance, every time you mention alpha and beta you are tacitly invoking the CAPM, because the very separation of alpha and beta stems from the CAPM model. A brief history of time Lets take a step back and examine a brief history of the origins of CAPM. It all started way back in the 1950s when Harry Markowitz was working on his PhD. Markowitz created a wonderful tool which allows investors to calculate the weights to give each stock (given expected return, expected risk, and the correlation) in order to achieve the portfolio with the greatest return for a given level of risk. Effectively investors using the Markowitzs methods will have mean-variance efficient portfolios that is to say; they will minimize the variance of portfolio return, given expected return, and maximize expected return given the variance. Markowitz gave the world a powerful tool that is much used and loved by quants everywhere. However, from there on in, the finance academics proceeded down a slippery slope. Somewhere around the mid-1950s Modigliani and Miller came up with the idea of dividend and capital structure irrelevance. They assumed that markets were efficient (before the efficient market hypothesis was even invented), and argued investors didnt care whether earnings were retained by the firm or distributed as income (this will be important in a little while). In the early 1960s the final two parts of efficient markets school dawned into the unsuspecting world. The first of these was CAPM from Sharpe, Litner and Treynor. In the wonderful world of CAPM all investors use Markowitz optimization. It then follows that a single factor will distinguish between stocks. This all encompassing single factor is, of course, beta. The second wa