Don’t be too quick to dismiss CAPM

Posted in: i-Blog, The Investor columns on August 20, 2020

This is one of a series of columns that were produced for Moneyweb Investor in which Stuart Theobald explores the intersection of philosophy of science and finance. This followed an earlier series for Business Day Investors Monthly on the same theme. This column was first published in April 2017.

It’s become popular to think investors are irrational. A growing hoard of behavioural economists are employed to explain biases in investment decision making. Saying one should use classic financial theories like the Efficient Markets Hypothesis and the Capital Asset Pricing Model will often get you laughed out of the room.

Except that the reality is loads of investors do use them. And if you want to know what “the market” is “thinking” then you have to use them as well. This isn’t to say that those theories are fundamentally right, but only that if everyone else uses them, then you need to too. Else you won’t know what is causing prices to move.

The CAPM is a theoretical model that allows you to calculate what sort of return you should expect from a share. It considers the volatility of the share price compared to the market, and basically says that it if it’s more volatile than the market then you should get a higher return for investing in it. This is a kind of equilibrium condition – you wouldn’t invest in a stock if there was a less risky alternative with the same return, so returns have to adjust to match the risk. In the model, risk is treated as volatility. When people deride finance theories, the CAPM usually comes in for much abuse. It has been shown to be a poor predictor of market returns, with Nobel prize winner Eugene Fama championing the empirical challenge.

But, while CAPM may be weak at predicting long term price trends, it may be exactly the right way to decide what to invest in. If everyone believes it’s the best model then it becomes true that it’s the best model. It’s like the little book of second hard car prices that every dealer consults when figuring out what to offer you for your car. It makes it true that the price in the book is an accurate figure for what you’d get for it, because it was in the book in the first place. In the same way, the fact that everyone uses the CAPM makes it true that it is a good guide to the prices in the stock market. Of course, new information may come out later which ends up making it a bad or better-than-expected investment, but at the time the little book was the best price you had.

There have been various studies that asked financial managers how they make their investment decisions, and the CAPM has come up often as an answer. The answer from the behaviourists is that people may often say they’re being rational, but then make decisions that are quite different. The gap between peoples’ reported behaviour and actual behaviour is well documented. But a recent study of market prices provides strong evidence that investors really are using CAPM[1].

The authors studied cash flows in mutual funds. The idea is that investors into such funds decide which fund to put their money in on the basis of its relative performance. If it is outperforming the market it will attract inflows, but cash will walk out the door if it is underperforming. The useful thing about mutual funds is that cash flows don’t affect prices – the price of the fund is a function of the underlying investments, not the cash flows. That makes it feasible to isolate investor decisions from pricing data – they are technically independent, unlike in the case of normal stock prices which are affected by supply and demand. The key question to test for is whether investors choose funds not just on their over- or under performance in terms of returns, but also on the basis of their historic volatility and correlation with market returns as the CAPM would say they should. In other words do investors pick funds according to CAPM or some other theory?

The authors tested the CAPM against several other decision making models, including the famous Fama and French multifactor model. Turns out the CAPM explains investor behaviour better than any of the alternatives. They did not test any explicit behavioural rules. Most behavioural analysis explains exceptions rather than providing a comprehensive standalone decision rule so I’m not aware how one could test such a rule. But from what was tested – blindly going to whatever fund has the highest returns, using CAPM, or using Fama & French, the CAPM was the top performer. It only accounted for about 63% of the decision making so there may well be a better model out there, but so far we don’t know what it is.

I like studies like this because they demonstrate that we have to be careful with how persuaded we are by behavioural and other accounts of stock market returns. I often think that those who roundly dismiss rationality in financial markets are moving too quickly. CAPM may be a case of what sociologists call “performativity”, the idea that a theory makes itself true by directing how everyone should behave. Alternatively, it may be something that must be true if it is simply encapsulating the idea that investors rationally trade off risk and return. Whatever the reality is, investors would be wise to be well aware of the CAPM expected returns. Everyone else in the market is.

[1] Jonathan B. Berk and Jules H. van Binsbergen. “How Do Investors Compute the Discount Rate? They Use the CAPM”. Financial Analysts Journal Second Quarter 2017. Vol. 73. No. 2

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