THE CAPM: ALIVE AND WELL?

A REVIEW AND SYNTHSIS

HAIM LEVY Hebrew university and Center of Law and Business September 2008

ABSTRACT
Mean-Variance analysis and the CAPM are two pillars of modern finance. Yet, these two models are strongly criticized on theoretical and empirical grounds. Theoretically, it is claimed that expected utility is invalid, some of the other assumptions which underline these models are invalid, and that the MeanVariance criterion may lead to paradoxical choices. These models are criticized empirically because the distributions of rates of return are far from being Normal and the CAPM has only negligible explanatory power. We show in this paper that the M-V and the CAPM survive the theoretical criticisms, though the expected utility model does not. Also, it is shown that despite the negative empirical results, with ex-ante parameters the CAPM can not be rejected. Furthermore, experimental studies which use ex-ante parameters strongly support the CAPM.

The Main Theoretical Criticism

1. 2. 3.

4.

Allais (1953) EU Roy (1952) EU Risk Aversion? (F&S, 1948), Markowitz (1952), Swalm (1966), K&T (1979), (1992) Baumol (1963), Leshno & Levi (2002) Paradoxes of M-V rule.

The Main Theoretical Criticisms of EUT, hence of the CAPM

1.

Allais (1953) criticizes EUT. He shows that using EUT in making choices between pairs of alternatives, particularly when small probabilities are involved, may lead to some paradoxes within EUT theory. Hence, it casts doubt on the validity of EUT which is the foundation of the M-V rule and CAPM. This paradox motivated the idea of using decision weights, see below.

The Main Theoretical Criticisms of EUT, hence of the CAPM

2.

Roy (1952) also criticizes EUT. He asserts that, "A man who seeks advice about his actions will not be grateful for the suggestion that he maximizes expected utility" (see Roy, 1952 p. 433). He suggests that people should rely on Safety First (SF) rule rather than EUT. If one accept Roy's claim, EUT is generally invalid, hence also the M-V and the CAPM is not intact

The Main Theoretical Criticisms of EUT, hence of the CAPM

3.

Even if EUT is intact some fundamental papers question the validity of the risk aversion assumption. Just to mention a few of these studies, Friedman and Savage (1948), Markowitz (1952b), Swalm (1966), Levy (1969) and Kahneman and Tversky (1979) claim that the typical preference must include risk-averse as well as risk-seeking segments. Thus, the variance can not be an index for risk, which casts doubt on the validity of the CAPM.

The Main Theoretical Criticisms of EUT, hence of the CAPM

4.

Prospect Theory (PT) of Kahneman and Tversky (1979) and its modified version, Cumulative Prospect Theory (CPT) of Tversky and Kahneman (1992) show that subjects behave in contradiction to what is predicted by EUT, hence they reject EUT which, once again, indirectly casts doubt on the validity of the M-V analysis and the CAPM. It is worth noting that the CPT's criticism of EUT is quiet general and has various dimensions, beyond the criticism of the shape of the preference mentioned in point 3) above.

The Main Theoretical Criticisms of EUT, hence of the CAPM

5.

Baumol (1963), Leshno and Levy (2002) and Levy, Leshno and Leibowitz (2008) claim that the M-V rule is a sufficient but not a necessary investment decision rule, hence it is not an optimal rule, leading to an elimination of a portion ,or portions, of the M-V efficient frontier from the efficient set. Therefore, the market portfolio may be also eliminated from the efficient set, which has an ambiguous effect on the CAPM.

The Main Criticisms of the M-V and CAPM

1. 2. 3.

Normal Distributions? CAPM Test: F&F (1992) Negative Weights in the Efficient Portfolios

The Main Criticisms of the M-V and CAPM

1.

The M-V criterion and the CAPM rely on the Normal distribution assumption. Numerous studies test the goodness of fit of actual rates of return distributions to the Normal distribution. Almost in all cases the null hypothesis asserting that the distribution of rates of return is Normal is strongly rejected, hence one of the main justifications of the M-V analysis and the CAPM loses ground.

The Main Criticisms of the M-V and CAPM

2.

Testing the CAPM directly reveals only little support for the expected linear risk-return relationship, and in some cases it reveals a strong rejection of the CAPM, when beta reveals almost no explanatory power of the variation in mean returns. Numerous studies reveal this result, where the most famous and well cited paper falling in this category is the one by Fama and French (1992). For an excellent summary of the empirical results, see Fama and French (2004).

The Main Criticisms of the M-V and CAPM

3.

Deriving the M-V efficient set, it is generally found that some of the investment weights of the tangency portfolio are negative. Moreover, as the number of assets increases, it is shown empirically that the percentage of assets corresponding to the tangency portfolio with negative weights approach 50%. These findings contradict the CAPM, as to guarantee equilibrium the investment weights of the tangency portfolio must be all positive. In addition, if most investors in practice choose mainly a portfolio with positive weights, it implies that they do not choose by the MV rule, as selecting an optimal portfolio by the M-V rule yields many negative investment weights. Therefore, the existence negative weights imply that, in practice, investments are not selected by the M-V rule; hence the CAPM is not valid.

Allais Paradox
Allais paradox may be solved once one employs decision weights (DW), rather than objective probabilities (see Kahneman and Tversky (1979)). As can be seen later on in the paper, when Normal distributions is assumed and monotonic DW are employed, as suggested by Quiggin (1982) and Tversky and Kahneman (1992), all investors select their portfolios from those portfolios located on the Capital Market Line (CML), hence the CAPM is intact. Thus, one can use, on the one hand, DW to solve the Allais paradox, and on the other hand, with DW as suggested by CPT, the CAPM is valid.

Roy's Safety First Rule

Min Pr ( x < d )
p

(1)

Roy's Safety First Rule

Using Chebyceff's inequality Roy shows that the following holds, Pr {x > k } 1 k 2 Of course, this inequality is meaningful only if k is larger than 1. Choosing k= ( d ) This can be rewritten as, (2)

Pr {x > ( d )} 2 ( d )

(3)
2

This implies a fortiori that,

Pr {( x ) > ( d )} 2 ( d )
Hence,

2 (4) Pr (x < d ) 2 ( d ) Thus the goal according to Roy is to minimize the ratio, ( d ) , or alternatively to maximize the ratio,

( d )

(4a)

Figure 1
Mean

m
p1* p p1

m1 m2

d1 d2

Standard Deviation

Figure 2
How is the severe criticism of Roy on EUT reconciled with the fact that the CAPM which is derived in the EUT framework remains is intact?

U(x)

Figure 3
U(x)

To summarize Roy's criticism we have the following possible cases:

Case a: Here it is assumed that the riskless asset prevails and that for all investors that di is smaller than r. Also, it is assumed that risky assets do not dominate by FSD the riskless asset, and that there is no requirement to invest some portion of the wealth in the risky assets. This case is unacceptable because by Roy's rule, in equilibrium all risky assets vanish from the market in contradiction to the observed facts. We rule out this case, as also Roy does not claim that in equilibrium there will be no risky assets. Case b: In this case the riskless asset exists and the CAPM is intact as long as di< r and there is a constraint that some portion of the investment must be allocated to the risky assets.

To summarize Roy's criticism we have the following possible cases:

Case c: The riskless asset is not available, a case where the Zero Beta CAPM holds. Case d: In our view this is the most relevant case. The riskless asset may prevail and if it prevails it may be smaller or greater (or equal) than di. There is no constraint on investing in the risky or riskless asset. The preference is given by Figure 3, when both, SF and monotonicity are accounted for

Overcoming the risk - aversion assumption Theorem 1: Let F and G denotes two Normal distributions, then F dominates G by FSD iff, a) E F (x ) > E G (x ) b)

and

F (x ) = G (x )

(5)

Figure 4a
r '

Mean
m

Standard Deviation

Figure 4b
Cumulative Distributions
G

Return

Cumulative Prospect Theory

As T&K modified their Prospect Theory and suggest Cumulative Prospect Theory (CPT), we focus here only on CPT. By CPT the investor maximizes a value function of the form,
x if V(x ) = ( x ) if x0 x<0

(6)

w + (P) = w (P) =

[P [P

+ (1 P) P + (1 P)

(7)
1

Overcoming Baumol's and Almost M-V criticisms

Prospect G Prospect F Mean, Standard Deviation, 5 1 50 2

Overcoming Baumol's and Almost M-V criticisms

While Baumol's rule is based solely on an intuition, in a recent study Leshno and Levy (Leshno and Levy (2002) suggest new rules, called Almost Stochastic Dominance (ASD) and Almost M-V(AMV) denoted by SD* and M-V* rules, respectively. Also, Baumol published his page before the CAPM was published hence he analyzed the implication to the M-V efficient set while L&L analyzed also to implication to the CAPM. L&L show that there are cases where neither F nor G dominates the other yet, they suspect that in practice such dominance exists. To see this consider the following two Normal distributions:

( G ~ N , ) = N (1,1) ( F ~ N , ) = N (10,2 )

Figure 5a
Cumulative Distributions
G

Return

Figure 5b
Mean
U2

U1 r
G

Standard Deviation

Baumol suggets the following investment rule instead of the M-V rule: F dominates G iff, a) E F (x ) E G (x ) and (8) b) L F (x ) = E F (x ) k F L G (x ) = E G (x ) k G where k is larger than 1.

Figure 6a
Mean
r' c
m

b r a

Standard Deviation

Figure 6b
Mean
r' c m b

Standard Deviation

m r p = r + p m

(9)

m r = constant m

(10)

Figure 7
Mean
m'
b

r'

r''

m
a

Standard Deviation

Overcoming the empirical Criticism of the CAPM

The Normality assumption

It is well known that Normality (or an Elliptic distribution) is very crucial to the derivation of the CAPM. We also assume Normality in showing the validity of the CAPM in various scenarios. Numerous studies examine the Normality hypothesis with a clear cut result: the Normality distribution is statistically strongly rejected

The Normality assumption

The M-V rule is justified as an approximation to expected utility even when distributions are not Normal on two grounds: i) Levy and Markowitz (1979) have shown empirically that the M-V rule is an excellent approximation to expected utility (see also Kroll, Levy and Markowitz (1984) and Markowitz (1991)). The utility loss induced by adopting this approach has been found empirically to be negligible.

The Normality assumption

ii) Other studies estimate directly the financial loss rather than the utility loss due to the assumption of Normality, when the empirical rates of return actually are not distributed Normaly. For example, Duchin and Levy who employ the myopic preference find that the loss per 10,000 dollars investment is merely $2-$6, depending on the degree of the relative risk aversion parameter. To put things in perspective, suppose that the planned investment horizon is one year. The mean rate of return on risky assets is about 12% (see, Ibbotson 2007). Then, loosing $2-$6 per $10,000 investment implies that the mean rate of return drops, on average, from 12% to 11.94%-11.98%, a negligible loss.

The empirical tests of the CAPM

From these studies one is tempted to conclude that the CAPM is, at least empirically, invalid, which allegedly drastically reduces its value. We claim below that this is not the case: though the CAPM is rejected with expost parameters it can not be rejected on empirical grounds with ex-ante parameters, in particular with ex-ante beta or some components of this beta, quite a strong statement. Recall that the CAPM is stated by Sharpe and Lintner with ex-ante and not ex-post parameters.

The empirical tests of the CAPM

In the early tests of the CAPM the firstpass and secondpass regressions where defined as follows: First Pass:

R it = i + i R mt + e it

(11)

Second Pass:

R i = 0 + 1 i + i

(12)

We turn now to the difference between ex-post and ex-ante parameters. There are few approaches to incorporate these differences. Generally, it can be shown that accounting for even small possible differences between ex-post and ex-ante parameters the CAPM can not be rejected. Let us elaborate.

1) Exante beta
In testing the CAPM (see eq. (12)), it is assumed that beta estimated by eq.(11) is the correct ex-ante beta. We claim that taking into account possible difference between ex-post and ex-ante beta the CAPM can not be rejected. Indeed, Levy (1983), test the CAPM when such differences are taken into account. He shows that regardless of the possible measurement errors involved in the measurement of rates of returns, the CAPM can not be rejected on exante basis.

2) The efficiency of the market portfolio

Taking into account the possible difference between ex-post and ex-ante parameters, in a recent paper, Levy & Roll (2008) show that when only small changes in the sample means and standard deviations are done, the observed market portfolio is M-V efficient, which according to Roll (1977) implies that the linear CAPM is intact. They employ a novel "reverse engineering" approach.

"Surprisingly, slight variations of the sample parameters, well within the estimation error bounds, suffice to make the proxy efficient. Thus, many conventional market proxies could be perfectly consistent with the CAPM".

3) Negative investment weights

Using historical rates of return to derive the M-V efficient set it is generally found that some of the weights are negative. Of course with a small number of assets, e.g. 3-5 assets it is possible to get that all weights are positive. However, in the relevant case for testing the CAPM, when hundreds if not thousands of assets should be incorporated, negative investment weights always exists. Moreover, the percentage of negative weights becomes close to 50% of the assets included in the study when the number of assets increases. And one does not need to have astronomy large number of assets to obtain this result: Levy (1983) shows that even with 15 assets the percentage of negative weights is about 50%

"We show that the probability of obtaining a positive tangency portfolio based on sample parameters converge to zero exponentially with the number of assets. However, at the same time, very small adjustments in the return parameters, well within the estimation error, yield a positive tangency portfolio. Hence looking for positive portfolios in parameter space is somewhat like looking for rational numbers on the number line: if a point in the parameter space is chosen at random it almost surely corresponds to nonpositive portfolio (an irrational number); however, one can find very close points in parameter space corresponding to positive portfolios (rational numbers)"

4) Experimental studies which use exante parameters Using this technique Levy (1997) find a strong support for the CAPM with more than 70% explanatory power. Levy concludes

"..mean return and risk are strongly positively related when these parameters are determined on an exante basis , as claimed by SharpeLintner model" (see p.145).

4) Experimental studies which use exante parameters Bossaerts and Plott ( 2002 ), also find an experimental support for the CAPM .In their words

"when interpreted as the equilibrium to which a complex financial market system has a tendency to move, the CAPM received support in the experiments reported here"
(see p. 1110).

SUMMARY
a) Theoretical Criticisms of M-V and CAPM
The Criticism Allais paradox Roy SF Solution DW+FSD Zero Beta Model Constraint on Investment A SF Preference With Monotonicity No need for Risk Aversion FSD FSD: All will choose portfolios from M-V efficient frontier with CPT (Using FSD) M-V efficient frontier is modified but the CAPM is intact

Risk-Seeking (F&S, Swalm, K&T) Prosoect Theory Baumol and Leshno & Levi M-V leads to paradoxes in choices

b) Empirical Criticisms
The Criticism The Normality is Rejected Solution Approximation with a small utility log and small Llinear log (2$ per 10,000$) With the use Ex-Ante Data on beta (Levy) or other parameters (Levi & Roll), one can not reject the CAPM Negative Weights of the Tangency Portfolio (1983) With A Small change in [Ex-Ante] a XXX portfolio is found

Direct CAPM Tests (F&F 1992,2004)

Experimental Test With Ex-Ante Parameters Show That The CAPM is Strongly Supported