Death of the Capital Asset Pricing Model

Abstract

The expected return of the stock described by the Portfolio Theory and the CAPM is not the true expected return of the stock in the real-life world. In the real-life world, the expected return could not replace the actual return of the stock, variance of the return could not replace the risk of the stock, and there is no trade-off between the expected return and variance of the return of the stock. An intensive analysis of the central prediction along with its implications which constitute the core of the CAPM lead to the following conclusions: (i) As a model of the determination of the expected return of the stock, the CAPM does not include the true expected return of the stock in the real-life world, which is the most critical factor. The CAPM is an unscientific description of the determination of the expected return of the stock in the real-life world, investors could not use it to calculate the true expected return of the stock in the real-life world. (ii) As a stock pricing model, the CAPM is an untrue description of the actual stock pricing in the real-life world. The CAPM can neither scientifically describe the actual stock pricing mechanism and process nor provide quantitative explanations on the formation of the actual return of the stock. The CAPM basically mixes up the determination of the expected return of the stock and the determination of the pricing of the stock, which are two issues of an entirely different nature. (iii) The CAPM central prediction that market portfolio is a mean-variance efficient portfolio is not supported by the real world data. In the real world, there is neither linear relationship nor any other relationship between the expected return of the stock and beta. Differences in betas are fully incapable of explaining the differences in expected returns across stocks and portfolios, beta is not the reasonable measure of the actual risk of the stock. (iv) The conclusion of this paper confirms with the current consensus within the profession that beta---the single risk factor is not quite enough for describing the cross-section of the expected returns of the stock.