CAPM still dominates the teaching of finance, but it was always nonsense because it relied on the following two assumptions:
“In order to derive conditions for equilibrium in the capital market we invoke two assumptions.
“First, we assume a common pure rate of interest, with all investors able to borrow or lend funds on equal terms.
Second, we assume homogeneity of investor expectations:
investors are assumed to agree on the prospects of various investments—the expected values, standard deviations and correlation coefficients described in Part II.”
Even Sharpe had to instantly admit that, as assumptions go, these two were doozies: he continued that “Needless to say, these are highly restrictive and undoubtedly unrealistic assumptions.” But never let realism get in the way of a neoclassical theory! He defended this nonsense with a twisted appeal to Milton Friedman’s “instrumentalist” methodology:
“However, since the proper test of a theory is not the realism of its assumptions but the acceptability of its implications,
and since these assumptions imply equilibrium conditions which form a major part of classical financial doctrine,
it is far from clear that this formulation should be rejected—especially in view of the dearth of alternative models leading to similar results.” (Sharpe 1964, pp. 433–434)
A major facet of CAPM was using the concept of Expected Value developed by John von Neumann and Oskar Morgenstern in Theory of Games and Economic Behavior. As is so often the case in economics, their work was misinterpreted. While CAPM involved blending neoclassical indifference curve analysis of individual behavior–which I debunked in the first lecture in this series–with von Neumann’s Expected Value analysis, von Neumann’s intention was to develop a numerical measure of utility and eliminate indifference curves from economic theory.
Despite these obvious reasons to dismiss CAPM, it took over the profession, and part of the reason for its success was its apparent close fit to the data at the time it was developed. But was this just a fluke, given the tranquil economic times during which CAPM was developed?
Even Behavioral Finance, which is critical of CAPM, has largely been developed on a misunderstanding of von Neumann. It applies the subjective concept of utility and expected returns to argue that there are numerous “paradoxes” where people don’t behave “rationally” given a financial choice, and that these “paradoxes” can’t be explained by risk aversion, loss aversion, or all other manner of conventional explanations.
In fact all these paradoxes disappear if objective probability is used, which is what von Neumann and Morgenstern insisted upon–literally–in their book:
“Probability has often been visualized as a subjective concept more or less in the nature of estimation. Since we propose to use it in constructing an individual, numerical estimation of utility, the above view of probability would not serve our purpose. The simplest procedure is, therefore, to insist upon the alternative, perfectly well founded interpretation of probability as frequency in long runs.” (von Neumann & Morgenstern 1944, p. 19)
Finally, economists normally deride the “payback period” means of deciding between investments, on the argument that this ignores the time value of money–an argument you’ll find in the Wikipedia entry on this topic. But John Blatt showed in in the 1980s that the payback period takes account of both the time value of money and uncertainty about the future, at least to a rudimentary level.
Here are the two Powerpoint Files for this lecture (Part 1; Part 2). I also neglected to upload the Powerpoint file for lecture 2; here they are (Part 1; Part 2). I’ll also edit the post the include them.
