The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CONFUSIONS REGARDING THE CAPM

Probably no other part of financial theory has been subject to more confusion, by professionals and amateurs alike, than the CAPM. Major areas of confusion include the following:

Confusion 1. Failure to distinguish between the following two statements:

The market is efficient in that each participant has correct beliefs and uses them to their advantage.

and

The market portfolio is a mean-variance efficient portfolio.

Confusion 2. Belief that equation (4.5) shows that CAPM investors get paid for bearing “market risk.” That this view—held almost universally until quite recently—is in error is easily demonstrated by examples in which securities have the same covariance structure but different excess returns.

 

Confusion 3. Failure to distinguish between the beta in Sharpe’s one-factor model of covariance,³⁷ and that in Sharpe’s CAPM.³⁸

The following sections present the assumptions and conclusions of the SL-CAPM and the Roy CAPM, and discuss the nature of these three historic sources of confusion, and their practical implications.