Markowitz and the CAPM

Abstract

There has been confusion between the Mean-Variance (MV) model and the Capital Asset Pricing Model (CAPM) due to the former providing the foundation for the latter. As the validity of the CAPM was challenged, the validity of the MV model suffered by association. A core implication of the CAPM is the mean-variance efficiency of the market portfolio. This property does not hold once some CAPM assumptions are relaxed. We focus on the limitations of the CAPM’s budget constraint. Markowitz never recommended portfolio selection without using realistic constraints - like bounds on short sales and portfolio weights. When such constraints are imposed, the market portfolio loses its efficiency, and the exact linearity of asset expected returns in beta fails. We use simulation analysis to examine whether beta is predictive when the market portfolio is inefficient. We also examine the irrelevance of residual risk in asset pricing. We conclude that neither beta nor the CAPM is dead.