CAPM: RIP

Here’s a good article from the Financial Times on the demise of CAPM, the Capital Asset Pricing Model. This model tried to explain the trade-off between risk and return in financial markets.
The verdict is that as a theory, it’s all swell. But in practice, CAPM doesn’t explain much. Studies have shown that low-risk stocks (meaning low beta) have done better than they should, and riskier stocks have continually come up short.
Of course, this is hardly the first time that an academic theory has got its ass handed to it by reality. What I find interesting, however, is the use (and abuse) of the concept of risk.
Although we’ve become used to language of risk, it’s actually a rather bizarre idea. Consider that we have just one word for it, but “risk” is used to describe many different things. For example, risk is reflexively assumed to be bad. But what about the risk of missing a great stock? That’s something that I’m always concerned with.
If there’s a trade-off between risk and return, then there’s an assumption that all investors measure risk the same way. The return part is fairly obvious. We can all agree what a 10% move is. But risk is subjective. What I might consider risky, you might not.
Another example is gold. Is gold very risk, or not risky at all? Going by its daily volatility, gold has often been very risky. Gold’s beta, however, is usually negative. I’ve always thought the allure of gold is that it has the least risk of losing its intrinsic value. After all, if we find ourselves living in the post-apocalypse, stocks and bonds aren’t going to be worth much, but gold will still have value (don’t laugh, there are investment advisors who say these things).
Once again, we have one word that’s used to describe many things, and everyone sees it differently.

Posted by on February 16th, 2007 at 10:59 am


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