CAPM, EMH, and other such Bunkum

I recently came across a fellow investor who was using beta to measure volatility of an asset in order to decide whether to purchase that asset. The following is my response.

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Beta is used in the Capital Asset Pricing Model to provide the expected return on an asset given the standard deviation of the price of that asset about its mean, which may vary with time, and the expected return on a benchmark asset, such as a zero-risk asset. The proper interpretation is as follows. Suppose you chose the 10-year treasury as your zero-risk asset. You immediately know your expected return on that asset. Now, consider a high risk asset such as GSS. Here, it is not simple to know what the expected return should be. The Capital Asset Pricing Model provides that answer: it is simply r_a = r_f + beta (r_m – r_f), where r_a is the expected return on the asset of immediate interest, r_f is the rate of return of a risk-free asset, and r_m is the expected rate of return of a benchmark asset, such as the S&P 500.

To compute beta requires simple linear regression which can be performed in Excel or any other relatively sophisticated spread sheet. Simply obtain the daily values for the market and compute the value of r_m = ∂S(t)/S(t) where S(t) is the value of the market at any given time and ∂S(t) is the change in the value of the market between any “base point” and the given time t. Perform the same simple computation for the price of the asset of interest. Then, do a linear regression with the quantity (r_m – r_f) as the abscissae values (x) and r_a as the ordinate (y) values. beta will be the slope of that regression result.

Personally, I think that the Capital Asset Pricing Model is extraordinarily useless as a measure of anything in the market. Of course, I know that Mr. William Sharpe won the Nobel Prize in Economics in 1990 for developing the model, but that does not mean that the model is of any practical use. Even if the Efficient Market Hypothesis and the Capital Asset Pricing Model had any basis in reality, what does the value of beta tell us about whether to invest in any given asset, say KO? In my humble opinion, it tells us nothing. I am not alone in my opinion. In 2004, E.F. Fama, another Nobel Prize Winner, observed that the empirical evidence demonstrated that the CAPM was invalid in real world application. He observed that passive funds that were invested in low beta, small or value, stocks tended to produce positive abnormal returns relative to CAPM predictions. Yes, one can fiddle with the CAPM to adjust for such real-world problems. Perhaps the better choice of action is to throw the entire CAPM, including beta, into the round file and use something that actually gives you some useful information about the stock that you are thinking of purchasing.

Perhaps you should leave your cash where it is for the next six months and carefully study the following two books very carefully: (1) Benjamin Graham: The Intelligent Investor; and, (2) John Burr Williams: The Theory of Investment Value. For some light reading, throw in Graham and Dood: Securities Analysis. It is worthwhile to set every thing in your world aside, except for your day job, until you have throughly understood every word in all three works. Then you will have all of the tools that Warren Buffet uses to select a company to buy.

Once you have done this, you will never, ever again think about using beta except for a late night joke.

I hope that this helps.

Nathan A. Busch

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