The Valor Blog.
Investment News and Views, Direct from Our Team.

The CAPM versus Rational Investing

by Marc Lerner

Finance students the world around are taught, as the method of finding the required rate of return of an asset appropriate for its risk, a model called the Capital Asset Pricing Model (CAPM). The key factor in determining the risk and hence required return of an asset in the CAPM is beta, a number that describes the volatility of the asset’s returns relative to the volatility of the market as a whole. A beta greater than one indicates that the stock is more volatile than the market, and a beta less than one indicates it is less volatile. As long as the beta is above zero, however, it means the asset still generally moves in the same direction as the market. This figure, beta, is fed into the model, which is then touted as taking into account – supposedly – all of the risk of the asset.

There are several problems with the CAPM that make it an irrational model to rely upon. Firstly, it equates risk with volatility, which, to a long-term value investor, is not accurate. Depending on your situation in life, the degree of volatility you can bear will undeniably be different – a university graduate who can expect a rising income for many years should be happier with far more volatility than a retiree who might need all their savings at a moment’s notice for a medical emergency. However, the truly key risk to a rational investor planning to hold shares over the long term is not the risk of volatile stock prices in the short term, but operational risk – the risk of the company being incompetently run, having demand for its products stop, being overtaken by competition or any of the myriad of other bad things that can happen to the business itself, which bears no direct relation to the volatility of the stock price, although there may be some level of correlation between the two. Temporary volatility in a downward direction, in fact, can be great if you want to buy businesses for as cheap as possible (or have the business you own shares in buy back its stock as cheaply as possible, if it has the cash to do so). A further complicating factor is the CAPM’s use of not just plain volatility, but volatility relative to the market as a whole – but this is only a concern for you if you are already invested in an index fund, rather than focused on picking out the best business you can find at the cheapest prices.

On top of this, the CAPM simply uses past data and projects it into the future, assuming no changes will occur between the two. But the future can, and often is, different from the past in fundamental way. Did the future of Apple change fundamentally with the entry of Samsung and all the other current competitors into the smartphone space? Would the future of Microsoft change fundamentally if Bill Gates were to return to working full-time for the company? The answers are obvious, not only for the operational risk of the company, but likely even for the volatility of the stock prices.

The reliance on volatility relative to the market and focus on past data can combine in the CAPM to form a theory of risk that is imperfect at best and absurd at worst. Imagine if tomorrow the price of Coca-Cola shares halved on no news, while the market stayed exactly where it is. This is, of course, very unlikely, but unless you assume markets are perfectly rational (which the CAPM does) it is not, in principle, impossible. According to the CAPM, the beta of the stock – its volatility relative to the market – just drastically increased, and it became a far riskier investment. But rationally, is it now more or less risky to buy? The answer is obvious.