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

TWO MEANINGS OF MARKET EFFICIENCY

CAPM is an elegant theory. With the aid of some simplifying assumptions, it reaches dramatic conclusions about practical matters. For example:

• How can an investor choose an efficient portfolio? The answer: Just buy the market.

• How can you forecast expected returns? The answer: Just forecast betas.

• How should you price a new security? The answer is once again: Forecast its beta.

CAPM’s simplifying assumptions make it easier to deduce properties of market equilibria, which is like computing falling body trajectories while assuming there is no air. But, before betting the ranch that the feather and the brick will hit the ground at the same time, it is best to consider the implications of some of the omitted complexities. The present section mostly explores the implications of generalizing one of CAPMs simplifying assumptions.

Note the difference between the statement “The market is efficient,” in the sense that market participants have accurate information and use it correctly to their benefit, and the statement “The market portfolio is a meanvariance efficient portfolio.” Under some assumptions the two statements are equivalent. Specifically, if we assume:

Assumption 1. Transaction costs and other illiquidities can be ignored.

 

Assumption 2. All investors hold mean-variance efficient portfolios.

 

Assumption 3. All investors hold the same (correct) beliefs about means, variances, and covariances of securities.

 

Assumption 4. Every ...