CAPM’S ABSURDITY & RATIONALITY IN MARKET This is the second time I am in HNSG Journal with my few words on the above captioned matter. Needless to quote the ever heard line learning is a continuing process, I thought after reading so many books and attending webcasts, lectures & seminars, finance is complete and there are no any pending things that we need to know and further to discover new ideas, but I was wrong and again the story of further reading is going on.

There are much more that we do not know in finance. We were taught that a good capital investment is one that has a positive NPV & no doubt we calculated NPV also, but we were given very little guidance about how to find positive-NPV projects, in fact no guidance. There are many puzzles left -some statistical and some theoretical in CAPM which we have missed in risk & return. I will be elaborating this later on. Market efficiency-we spend days in discussing rationality and in almost all theory and models we assume market is perfect, market behaves rationally and stocks are fairly priced if this is the case then why do we value the stocks & have Nobel Prize Winner who strongly believes on market irrationality. Explain & resolve the Payout Controversy. Factors determining success of new markets & new securities are yet to be taught. Merger Waves are to be detailed. We studied the markets, stocks, portfolio management almost every aspect then why Financial Systems are so prone to crisis. Let’s hope these problems will be finally solved in the decades to come.

The CAPM is about expected return. Expected returns on common stocks can vary quite a bit. One important determinant is the industry in which a company operates. The CAPM is an absurd model because its assumptions and its predictions or conclusions have no validity in practical/real world. If I go through the dictionary then I must agree that theory is an idea or set of ideas that is intended to explain facts or events and a model is a set of ideas and numbers that describe the past, present, or future state of something. We do have the statistical problems because the capital asset pricing model is hard to prove or disprove conclusively. Researchers are of the view that CAPM does not “explain facts or events”, nor does it “describe the past, present, or future state of something”. Although we have been using the model, this model is sometimes prone to error. We do make mistakes & lead to wrong conclusions in valuing companies, accepting/rejecting investment proposals, evaluating fund performance, pricing goods and services in regulated markets, calculating value creation and so on.

It is somehow easy to find out an investor’s expected return by asking him. However, it is impossible to determine the expected return of the market, because this parameter does not exist as different investors have different cash flow expectations and different expected (and required) returns to equity. One could only talk of the expected return of the market if all investors had the same expectations. But investors do not have homogeneous expectations.

Based on the research paper published in in Business Valuation Review by Pablo Fernandez, Professor of Finance I have tried to show you how far the assumptions are from reality.

CAPM Assumptions Reality Homogeneous expectations All investors have equal expectations about asset returns

Heterogeneous expectations Investors DO NOT have equal expectations about asset returns.

Investors only care about expected return and volatility of their investments

Investors also care about jumps, crashes and bankruptcies

All investors use the same beta for each share Investors use different betas (required betas) for a share

All investors hold the market portfolio Investors hold different portfolios All investors have the same expected market risk premium

Investors have different expected market risk premia and use different required market risk premia

The market risk premium is the difference between the expected return on the market portfolio and the risk-free rate

The market risk premium is NOT the difference between the expected return on the market portfolio and the risk-free rate

Almost all of the papers about CAPM published in journals in the last 48 years’ relay in one calculated beta per date. Different beta sources provide us with different betas.

Conclusion: We must recognize the capital asset pricing model for what it is: an incomplete but extremely useful way of linking risk and return. It is clear that both, the assumptions and the predictions/conclusions of the CAPM, have no basis in the real world. Valuation and capital investment is about required return. But we professionals sometimes mix (or assume that are equal) expected return and required return.

Ending this I begin with what we were and have been taught about markets ie, – “Markets are Efficient” It would be better if we say that market is rational for some of the time and not for all of the time. Let us see why researchers and professors disagree on the assumptions of Efficient Market Theory, even though the theory is strong but no theory is perfect. We often say that stock prices reflect everything about a company’s prospects and the state of the economy, then and there a thought comes in the mind of the investor that there is nothing good in doing any type of analysis as price already reflects all possible analysis. Had the markets been efficient there would be no question in valuing the stocks and the concept of overpriced/underpriced stocks could be an imaginary concept only. In efficient market price and value should be equal, practically we are not seeing these scenarios. We can prove that if they were efficient then some things should not happen. For example, the following should not exist: Cash Bargains; Debt-Capacity bargains; Over and under reactions; Closed-end fund puzzle and so on. Researchers believe that the efficient-market hypothesis ignores important aspects of human behavior as almost all of traditional economics is based on the notion of the rational man assumption. For instance, psychologists find that people tend to place too much emphasis on recent events when they are predicting the future. If so, we may find that investors are liable to overreact to new information again this may or may not come true in real practice. In an efficient market very few investors can beat the market.

In theory it is assumed that markets are efficient, managers do convey information honestly and in a timely manner to financial markets, and financial markets make reasoned judgments of the effects of this information on true value. As a result of which a company that invests in good long term projects will be rewarded, Short term accounting gimmicks will not lead to increases in market value, Stock price performance is a good measure of company performance.

In an efficient market it is not possible to find expected returns greater (or less) than the risk-adjusted opportunity cost of capital. This implies that every security trades at its fundamental value. If price equals fundamental value, the expected rate of return is the opportunity cost of capital, no more and no less. If price differs from fundamental value, then investors can earn more than the cost of capital, by selling if the price is too high and buying when it is too low.

Talking practically, we do have to go deeper for the assumptions made in EMT. Information (especially negative) is sometimes suppressed or delayed by managers seeking a better time to release it. Sometimes, firms release intentionally misleading information about their current conditions and future prospects to financial markets.

Investor irrationality is also supposed to be one the prime factor that brings a hindrance in EMT assumptions. Financial markets are manipulated by insiders & prices do not have any relationship to value. Investors are short-sighted, and do not consider the long-term implications of actions taken by the firm.

The public is said to have learned that stocks always go right back up after they go down. In reality, stocks can go down, and stay down for many years. They can become overpriced and underperform for many years.

We have learned that stocks must always outperform other investments, such as bonds, over the long run, and so long-run investors will always do better in stocks. Again we are wrong here, we have seen evidence that stocks have not always outperformed other investments over decades-long intervals, and there is certainly no reason to think they must in the future.

Conclusion: It’s again an issue before us what we believe on markets.

I have tried to come something in original & share whatever I have learned and let me assure you that I am not biased on the assumptions and reality. These discussions are only highlights. For detailed contents please go through the

references.

References: Damodaran.com(Books/Blogs/Webcasts) Books- “Irrational Exuberance”, RWJ Corporate Finance, Brealey Myers Allen- Corporate Finance, Teaching materials of my teachers.

Thank you for reading!!!!! Niraj Thapa

niraj_thapa@hotmail.com

nirajlearning.blogspot.com