Theoretical and Empirical Limitations in the Validation of the CAPM in Portfolio Investments - Expository Essay

Introduction

Capital asset pricing model is a popular approach that is used to establish the return on investment and the risk involved. This approach is used by organizations to guide investment decision making and promote organizations profitability. Capital asset pricing model is a very attractive approach for organizations to validate their investment portfolio because it is able to offer powerful and intuitive predictions on the relationship between the risk and return on investment. However, capital asset pricing model has some drawbacks that reduce its applicability in making financial investment decisions. There are both theoretical and empirical limitations towards the application of capital asset pricing model. The theoretical and empirical limitations experienced in the application of the capital asset pricing model are as a result of poor empirical record which fails to invalidate in detail the way it is applied. On the other hand, the theoretical limitations are as a result of numerous simplified assumptions and also the difficulty in carrying out valid tests for the model (Elbannan, 2014).

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Limitations in the Validation of the CAPM

Tests carried out by Fama and French show that betas are not statistically related to the returns on investment which has resulted in the conclusion that beta is not suitable in establishing the cross sectional difference in returns on investment and it is not appropriate therefore to use beta to measure the risk involved in an investment portfolio (Fama & French, 2004), Studies carried out in the past have pointed out that there are deviations in the linear capital asset pricing model risk of return trade off as a result of other significant variables. There is a variation in the average returns that cannot be explained by the capital asset pricing model beta which is also another important empirical limitation of using capital asset pricing model to establish the feasibility of a business portfolio. The basic assumptions inappropriateness is an additional limitation of the capital asset pricing model such as the assumption that the information is free and unconditionally available to all investors in a market as well as the assumption that most capital markets are balanced and efficient which is rarely the case (Roll, 1977).

Conclusion

Stephen A. Ross argues that there are significant problems in the application of capital asset pricing model due to several potential errors. A simple model like the capital asset pricing model cannot describe the behavior and function of a complex financial market. The empirical approach of the capital asset pricing model has not been validated due to the lack of unequivocally support of the validity of the model. The betas used in the establishment of the risk and return on investment using the capital asset financing model is largely unstable all through time which is a cause of problems especially if the betas are estimated from a historical date to calculate costs of equity to establish the future cash flows. Betas used in the capital asset pricing model are undeniably related to the past returns due to the relationship between the total and systematic risk involved it is futile to distinguish their overall effects empirically (Perold, 2004).

References

Elbannan, M. A. (2014). The capital asset pricing model: an overview of the theory. International Journal of Economics and Finance, 7(1), 216.

Fama, E. F., French, K. R.(2004), The Cpaital Asset Pricing Model: Theory and Evidence" Journal of Economic Perspective, Vol. 18, No. 3, pp.25-46.

Perold, A. F. (2004), "The Capital Asset Pricing Model" Journal of Economic Perspective, Vol. 18, No. 3/2004, pp. 3-24.

Roll, R. (1977), "A Critique of the Asset Pricing Theorys Tests Part I: On Past and Potential Testability of the Theory" Journal of Financial Economics, Vol. 4, No. 2/1977, pp. 129-176.

Stephen A. Ross, The Arbitrage Theory of Capital Asset Pricing, Journal of Economic Theory, December 1976, p. 341.