Beyond Diversification Series: Part One Continued

“The expected return for all tradable assets should be a function of the level of interest rates.” – Jean-Paul Page  

Anyone who has taken a course in finance knows about the Capital Asset Pricing Model (CAPM), which was independently developed by Jack Treynor, Bill Sharpe, John Lintner, and Jan Mossin in the 1960s. For multi-asset investors, the CAPM presents a basic way to estimate expected returns.

Expected return = Risk-free rate + Beta (market risk premium)

I was first introduced to the history behind the CAPM as an undergraduate when a professor gave me a copy of the book Capital Ideas, by Peter L. Bernstein—a masterfully written account of the beginnings of modern finance. This book had more influence on my interest in finance and career choices than any other book I have ever read. 

In Bernstein’s follow-up book, Capital Ideas Evolving, in which he discusses applications of the concepts presented in Capital Ideas, he concludes that the CAPM “has turned into the most fascinating and perhaps the most influential of all the theoretical developments described in Capital Ideas.” Similarly, in their ubiquitous textbook Modern Portfolio Theory and Investment Analysis, Edwin Elton and Martin Gruber describe it as “one of the most important discoveries in the field of finance.”

However, there are issues with the CAPM. Its derivation relies on a long list of questionable assumptions: Investors are rational, taxes and transaction costs do not exist, all investors have the same information, etc. Even Harry Markowitz, father of portfolio theory, has expressed misgivings about the widespread use of the CAPM.  

In a paper titled “Market Efficiency: A Theoretical Distinction and So What?” published in the Financial Analysts Journal in 2005, Markowitz writes about the model’s “convenient but unrealistic assumptions.” He focuses on one of the key, yet rarely discussed, building blocks of the model: the (clearly unrealistic) assumption that investors can borrow all they want at the risk-free rate. But, just like taking away the wrong Jenga piece will make the tower of blocks collapse, if we take away this important theoretical building block, the CAPM edifice crumbles. Markowitz demonstrates that the market portfolio is no longer “efficient,” which means that other portfolios offer a better expected risk-adjusted return, and the key conclusions and applications of the model are no longer valid (an interesting conclusion given the popularity of index funds). 

He acknowledges the theoretical relevance of the model, but, with a great analogy from physics, he argues that we should be aware of its limitations in practice:

Despite its drawbacks as illustrated here, the CAPM should be taught. It is like studying the motion of objects on Earth under the assumption that the Earth has no air. The calculations and results are much simpler if this assumption is made. But at some point, the obvious fact that, on Earth, cannonballs and feathers do not fall at the same rate should be noted and explained to some extent. Similarly, at some point, the finance student should be shown the effect of replacing [the model’s assumptions about borrowing at the risk-free rate and shorting] with more realistic constraints.

To estimate expected returns is to try to predict the future. It should be hard! In the absence of a crystal ball, any model will have its flaws. Despite the multi-decade academic tergiversations on its merit, the CAPM is as good a starting point as any, because it links long-term expected returns to an objective measure of risk and current interest rate levels.  

While discussions on expected returns often degenerate into never-ending debates about what the future holds, with the CAPM, we can make predictions in a somewhat agnostic, less controversial way. It’s hard to refute the argument that risk should be compensated: Asset classes with higher (undiversifiable) risk should have higher expected returns than those with lower risk, at least over a reasonably long time horizon. And as suggested in the quote from my father at the top of this article (he was a finance professor for over 40 years), the level of interest rates matters. Low rates, as in the current environment, should lower expected returns across capital markets.

You can find more information on this topic, including a review of long-term and short-term return forecasting models in my book, Beyond Diversification, What Every Investor Needs to Know About Asset Allocation (McGraw Hill, 2020). 

Treynor, Jack L. 1961. “Toward a Theory of Market Value of Risky Assets,” Unpublished manuscript.

Sharpe, William F. September 1964. “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk,” Journal of Finance, Volume 19, Number 3, pp. 425–442. 

Lintner, John. 1965. “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets,” Review of Economics and Statistics, Volume 47, Number 1, pp. 13–37. 

Mossin, Jan. 1966. “Equilibrium in a Capital Asset Market,” Econometrica, Volume 34, Number 4, pp. 768–783. DOI: 10.2307/1910098. 

Markowitz, Harry M. 2005. “Market Efficiency: A Theoretical Distinction and So What?” Financial Analysts Journal, Volume 61, Number 5, pp. 17–30. DOI: 10.2469/faj.v61.n5.2752. 

 Important Information 

The views contained herein are as of the date noted on the material. My views are my own and may differ from those of other T. Rowe Price investment professionals, portfolio managers, and associates. 

T. Rowe Price Associates, Inc.